i-invest magazine January 2016

i-invest

How bosses can help their staff get more from their DC pots!

Give the man a fish and you feed him for a day, teach the man to fish and you feed him for ever.

Are Penny Blacks the New Pension Funds?

As investors seek diversification in their portfolios, rare tangible assets are becoming increasingly popular among those seeking diversification and long-term returns. and Institutional Alternative Asset Industry.

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Editors Letter Matti Leppälä of Pensions Europe introduces this edition by outlining the EU white paper on pension policy ‘An Agenda for Adequate, Safe and Sustainable Pensions’, to better balance the time spent in work and retirement and developing complementary private retirement savings. Fergus Moffatt Head of Public Policy & Programme Director – UKSIF explains his thoughts on responsible investment.

News includes the agreement to set Northern Ireland’s corporation tax rate at 12.5% from April 2018 as part of the Stormont Agreement and an ECB Report on Financial Structures which reveals structural changes in the euro area financial sector.

The magazine then focuses on pensions and asset Management & Investment. Notable articles include Nigel Keohane, Director of research who explains the recent changes in the UK’s pensions landscape. Tony Williams, Head of Employer Services London Pensions Fund Authority writes about managing Employer Risk in the Local Government Pension Scheme.

Simon Howard, Chief Executive and Charlene Cranny, Programme Manager at UKSIF the History and Digital Future of Hedge Funds. Neville White, Head of SRI Policy & Research at EdenTree Investment Management Ltd reveals his thoughts on Ethical Investments and meeting the Research Challenge.

I hope you find something of interest in this packed edition, which has a strong focus on pensions reform from a number of contributors. Do feel free to contact me if you would like to submit an article for the next edition of the magazine or for the I-Invest website.

Foreword Head of Public Policy & Programme Director - UKSIF Fergus Moffatt I was delighted to hear this latest edition of i-invest would be dedicated to Responsible Investment.

In 2015 we saw the launch of the Sustainable Development Goals, the biggest Good Money Week campaign ever, and the first ever global climate agreement following COP 21 in Paris. Responsible investors are already well placed to take advantage of opportunities stemming from these developments and able to mitigate potential long-term risk through integration of ESG factors in decision making processes. This edition of i-invest highlights international best practice and I hope it will act as an advertisement for the excellent work taking place globally in responsible investment.

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Contents Good things come in small packages

By Matti Leppälä Page 4.

News Pages 6-9.

Are Penny Blacks the New Pension Funds?

As investors seek diversification in their portfolios, rare tangible assets are becoming increasingly popular among those seeking diversification and long-term returns. Page 10.

Investing in Emerging Market Equities: How to achieve double alpha Over three years ago, Milltrust International, launched a ‘double alpha’ EM product and now finds itself amongst the best performers in the emerging markets equity asset class for its GEMS multi-manager portfolio. Page 14.

The New World of Operational Due Diligence Responding to a Regulated and Institutional Alternative Asset Industry.

By Christopher Addy, CPA, CA, FCA, CFA® Page 16.

Magni Global

By Kurt Lieberman, Chief Executive Officer Page 22.

Mexican Energy Industry Opening of Mexican Energy Industry Driving Energy Infrastructure Investment and Breathing New Life into Petrochemicals, IHS Says. Page 24.

The Impact of Mifid II on the Anatomy of an Investment

By Gary Stone, Chief Strategy Officer for Bloomberg Trading Solutions Page 28.

How bosses can help their staff get more from their DC pots!

By Henry Tapper. Henry is Founding Editor of Pension PlayPen and Director of First Actuarial Page 30.

Sustainable Food Supply Chain

By Jeroen Brand Page 32.

Pensions in Europe

By Matti Leppälä Page 36.

Ethical Investments

By Neville White, Head of SRI Policy & Research at EdenTree Investment Management Ltd. Page 38.

Pension Reform From DB to DC

By Peter Bradshaw, National Accounts Director, Selectapension Page 42.

ESG Factors Govern Investment Decisions Could using ESG across a firm’s full investment portfolio be the future of investment?

We speak to Rebecca Maclean, Responsible Investment Analyst at Standard Life, on how this could change the way ESG is adopted throughout the investment industry. Page 44.

UK SRI Green Money

By Simon Howard, Chief Executive, UKSIF, Charlene Cranny, Programme Manager, UKSIF Page 46.

Pension Liabilities Managing Employer Risk in the LGPS Page 50.

Asset Allocation & Investment 2016 Series

By Oliver Hambleton Page 54.

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Good Things Come in Small Packages

By Matti Leppälä

EU white paper on pension policy from 2012 ‘An Agenda for Adequate, Safe and Sustainable Pensions’ has two main themes to ensure pensions are adequate and sustainable: Better balancing the time spent in work and retirement and Developing complementary private retirement savings. A lot has been done in recent years around Europe that people can and also have to stay longer in working life and thus the economic sustainability of pensions has significantly improved. But whether the pensions will be adequate remains a great concern.

With complementary private retirement savings the EU means two things: Occupational i.e. workplace pensions and private individual pensions. Much more seems to be going on in trying to develop private individual pensions.

The newest idea is to develop Pan-European private pension products and this is now also part of the European Commission’s flagship Capital Markets Union project. More than half of Europeans don’t have a workplace pension and private pension products will not be an affordable alternative for most of them. But they can those who don’t have access to workplace pensions. Whether a new Pan-European personal pension product is needed remains to be seen.

Many, including the European Parliament and social partners, have urged the European Commission to come up with measures that encourage Member States to facilitate participation in occupational pensions and to make proposals for promoting such pensions where they do not yet exist. But not much has happened. The UK auto enrolment reform is encouraging as now millions who didn’t are now building up their pension. Hopefully people will know and understand that they need to stay in and save for their own pension.

Europe needs much more funded pensions.

But instead of helping to build more opportunities for workplace pensions the EC and European supervisory authority EIOPA in Frankfurt have been too interested in trying to create harder solvency and other requirements for pension funds. This is not the right EU policy and pension funds have fought these plans and luckily also quite successfully.

Workplace pensions belong to the competence of the social partners and the member states, not the EU. No overall EU-wide sweeping reform is feasible or desirable. But many smaller improvements are necessary. Good things come in small packages.

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27 Global Investors Representing $11trn AUM Back ‘Paris Green Bonds Statement’ On 9th December 2015 in Paris: Twenty-Seven global investors representing over USD 11.2 trillion of total AUM issued the ‘Paris Green Bonds Statement,’ (PGBS). Signatories committed to support policies that drive the development of long term, sustainable global markets in green bonds as part of climate finance solutions.

Paris Green Bonds Statement signatories undertake to work through bodies like the Climate Bonds Initiative, with governments, development institutions, cities, commercial banks, NGOs and others. They commit to working to “grow a large and robust market that makes a real contribution to addressing climate change.”

The Paris Green Bonds Statement calls on: • Industry experts and stakeholders: To develop clear standards for the climate change impacts and benefits of bond financed projects; • Bond Issuers: To ensure transparency around the use of bond proceeds and their impact; • Governments: to develop projects that can be financed by green and climate bonds.

Past years have seen the rapid growth of a Green Bonds and Climate Bonds market as a mechanism to tap the global bond market to finance solutions to climate change. USD 40 billion of Green Bonds have been issued this year, topping the USD 37 billion of 2014 issuance, and far above the USD 11 billion for 2013.

The use of green bonds as a climate finance mechanism has been increasingly raised by delegates and presenters in a variety of COP21 fora over the last seven days.

Climate Bonds CEO, Sean Kidney said: “Enormous opportunity exists to deploy green bond financing, to renew existing, ageing urban infrastructure and also in emerging markets and economies that will be building new energy and urban networks in the coming years.”

“The one hundred and eighty-five INDCs on the table here in Paris are one of the greatest achievements on the COP21 process.

They will need climate financing to help reach their expressed goals and objectives.

The Paris Green Bonds Statement reflects widespread institutional investor views that green and climate bonds have a part to play in sustainable and responsible investment to address climate change. “ The PGBS was coordinated by the Climate Bonds Initiative.

About the Paris Green Bonds Statement: The PGBS builds on earlier investor statements calling for increased use of green bonds in climate finance, actively policy by governments and increased participation by investors and stakeholders to build deep, liquid and robust green bond markets. A full list of signatories is below.

Paris Green Bonds Statement Signatories: • ACTIAM - Jacob de Wit, CEO • Addenda Capital - Brian Minns, Sustainable Investing Specialist • Affirmative Investment Management Stuart Kinnersley, CEO & Co-Founder • AllianceBernstein - Peter S. Kraus, Chairman and CEO • Allianz Global Investors - Franck Dixmier, Global CIO Fixed Income • Amundi Asset Management - Bernard Carayon, Deputy CEO • APG Asset Management - Herman Slooijer, Managing Director Global Credits • AP1/Första AP-Fonden - Mikael Angberg, CIO • AP2/Andra AP-Fonden - Ulrika Danielson, Head of Communications • AP3 /Tredje AP-fonden - Peter Lundkvist, Head of Corporate Governance • AP4/Fjärde AP-Fonden - Arne Lööw, Head of Corporate Governance & Dr Ulf Erlandsson, Snr Portfolio Manager Credit • Aviva Investors - Dr Steve Waygood, Chief Responsible Investment Officer • AXA Investment Managers - Andrea Rossi, CEO

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• BlackRock Inc - Kevin Holt, Co-Head of Americas Fixed Income • BNP Paribas Investment Partners - Helena Viñes Fiestas, Head of Sustainability Research • Calvert Investments - Bennett Freeman, Senior VP, Sustainability Research & Policy • California Teachers’ State Retirement System CalSTRS - Jack Ehnes, CEO • F&C Investments - Vicki Bakhshi, Head of Governance & Sustainable Investment • Legal & General Investment Management - Meryam Omi, Head of Sustainability • Mirova — Hervé Guez - Director Responsible Investment Research • MN - Anatoli van der Krans, Senior Advisor Responsible Investment & Governance • Natixis Asset Management - Hervé Guez, Director of Responsible Investment Research • NEI Investments - Robert Walker, Vice President Ethical Funds & ESG Services • NN Investment Partners - Hans Stoter, CIO • Pax World Mutual Funds - Dr Julie Fox Gorte, Senior VP, Sustainable Investing • Raiffeisen Capital Management - Dieter Aigner, Board Member • Zurich Insurance Group - Manuel Lewin, Head of Responsible Investment Supported by the: • Ceres Investor Network on Climate Risk USA • Investor Group on Climate Change - Australia & New Zealand See more at the Climate Bonds Initiative: https://www.climatebonds.net/2015/12/today-cop21-27-global-investors-representing11trn-aum-back-paris-green-bonds-statement#sthash.z2E7HTvT.dpuf

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Governance and Administration of Public Service Pension schemes From 1 April 2015 The Pensions Regulator became involved in monitoring and advising Public service Pension schemes including the Local Government Pension Scheme. This outlines clear responsibilities for Scheme Managers, Pension Board members and scheme employers.

The guide can be viewed under this link: http://www.thepensionsregulator.gov.uk/docs/ code-14-public-service.pdf Some of the key areas that the Pensions Regulator will monitor are as follows: Pension Board members have knowledge and understanding in key areas.

Good internal Risk controls are in place, including systems and procedures. Controls must be administered and managed in line with scheme rules. Risk registers should be in place for all schemes.

Maintaining complete, accurate and up to date records. LPFA assess data quality on an annual basis.

All information to members is clear and easy to understand.

Paperwork is completed by the employer to allow the prompt payment of benefits.

Reporting Breaches to the Pensions Regulator Funds are required from 1 April 2015 to identify breaches of the law and report if necessary. Scheme managers and pension board members (amongst others) are required to report breaches which are considered of material significance to a public sector fund.

In addition funds are required to maintain a register of issues both reportable and non-reportable which can be viewed by the Regulator at any time. This would include the breach and a red, amber green rating. Red breaches are immediately reportable to the Regulator.

The Regulator can choose to visit employers or levy financial penalties for persistent non-compliance and the log would include employer details.

Schemes must have an Internal Dispute Resolution Procedure (IDRP) in place.

Employer responsibilities Employers will be responsible for assisting in a number of areas including: Resolving data queries So Annual benefit statements are issued by 31 August each year.

The Regulator will expect all end of year queries to be resolved by the employer so this deadline can be met.

Revised Life Expectancy Figures Reduces Private Sector Pension Schemes Liabilities The Institute and Faculty of Actuaries have revised the CMI Mortality Projections Model used by the vast majority of UK pension schemes when making assumptions about the life expectancy of their members.

The 2015 version of the model predicts that life expectancies have fallen compared to 2014. A male currently age 65 is now predicted to live for 24 years and five months on average. This is four months less than the 2014 model predicted. As a result, those who use this model will see their liability come down.

Hugh Nolan, Chief Actuary at JLT Employee Benefits, comments: “The latest actuarial model, released…predicts that life expectancies have fallen compared to 2014. A male currently age 65 is now predicted to live for 24 years and 5 months on average, 4 months less than the 2014 model predicted.

“This reduces the liabilities of UK private sector pension schemes by some £15bn. While this is only 1% of the total liabilities held, it will reduce the deficit in a scheme that is 90% funded by 10% of that deficit, which can be extremely helpful for individual schemes struggling to reach full funding.

“Similarly public sector pension liabilities (including State pensions) could reduce by around £70bn. This will be a very welcome boost to the Treasury!

“This is a significant blip in life expectancy trends and is unprecedented in recent times.

Trustees and employers need to consider the new information carefully and decide whether to adopt the new projections when updating their figures. The latest mortality statistics may just be a random variation or they could indicate a genuine slowing of the rapid improvements we’ve seen recently. We may need to wait for another major change in lifestyles or significant medical advances before longevity accelerates back to the same level as over the last few years.”

Francis Fernandez, Senior Adviser at Lincoln Pensions, comments: “The new tables serve as a timely reminder to trustees and employers of DB pension schemes that any mortality tables are simply a guide to the future. It’s probably better to be pragmatic and reflect any step changes in the tables - good or bad depending on one’s perspective - over a period of years. This will give sufficient time to see if the revised tables are borne out in practice, noting the sponsor covenant will be there to support the impact of adverse experience.”

Common and conditional data quality meets the Regulator expectations and as in 2014 we were issued annual data statements to all employers in September 2015.

Contribution data and payment is made to the pension fund by the 22 of the following month (for electronic payments) to which the contributions relate.

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Increase in leverage products turnover on European structured securities market; New issues considerably higher / European structured products market turnover stands at 34.7 billion Exchange turnover in investment products and leverage products decreased on Europe’s financial markets in the third quarter of 2015. Compared with the period from April to June of the year, the volume fell by 10 percent to EUR 34.7 billion. However, there was a significant increase of 32 percent year on year. This is one of the outcomes of an analysis by Derivative Partners AG of the latest market data collected by the European Structured Investment Products Association (EUSIPA) from its members.

The members of EUSIPA include: Zertifikate Forum Austria (ZFA), Association Française des Produits Dérivés de Bourse (afpdb), Deutscher Derivate Verband (DDV), Associazione Italiana Certificati e Prodotti di Investimento (ACEPI), Swedish Exchange Traded Investment Products Association (SETIPA), Swiss Structured Products Association (SSPA) and the Netherlands Structured Investment Products Association (NEDSIPA).

Banks issued a total of 933,963 new investment products and leverage products in the third quarter of the year. Compared to the period from April to June, the new issues activity recorded growth of 15 percent. This was a significant 57 percent increase year on year.

A total of 178,460 new investment products were launched, accounting for 19.1 percent of all new issues. All in all, 755,503 new leverage products were listed. They therefore accounted for 80.9 percent of the aggregate volume of new issues.

The trading volume of investment products on the European exchanges stood at EUR 9.0 billion in the third quarter of the year, accounting for a share of 25.9 percent of the total turnover. Exchange turnover dropped by 35 percent from the previous quarter. This represented a slight decrease (of 2 percent) year on year.

At the end of the third quarter, the market volume of investment and leverage products in Austria, Germany and Switzerland stood at EUR 220.1 billion – down 21 percent on the second quarter of the year. The volume fell by 13 percent compared with the third quarter of the previous year.

At the end of September the market volume of investment products amounted to approximately EUR 211 billion and thus was 10 percent lower than in the same quarter of the previous year. When compared with the second quarter of 2015, there was also a decrease of 10 percent.

The outstanding volume of leverage products at the end of September was EUR 9.1 billion.

This represents a decline of 79 percent from the second quarter of 2015 and 48 percent in comparison with the third quarter of 2014.

However, according to the latest figures provided, there has been a particularly sharp decline in the outstanding volume of leverage products in Switzerland. These figures are currently being checked again by the Swiss National Bank.

Source: EUSIPA - European Structured Investment Products Association www.eusipa.org

The trading volume of leverage products such as Warrants, Knock-Out Warrants and Factor Certificates totalled EUR 25.7 billion in the period from July to September. They therefore accounted for 74.1 percent of total turnover. Exchange-traded volume increased by 4 percent quarter on quarter. This represented a strong year-on-year growth of 50 percent.

At the end of September the exchanges of EUSIPA member countries were offering 595,225 investment products and 817,158 leverage products. The number of products listed grew by 1 percent from the preceding quarter and increased by 18 percent year on year.

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ECB Report on Financial Structures reveals structural changes in the euro area financial sector In late October 2015, the European Central Bank has published a Report on Financial Structures (RFS) 2015. The RFS succeeds the Banking Structures Report (BSR) and covers the banking sector and other financial intermediaries, including insurance corporations and pension funds (ICPFs), as well as non-bank and non-insurance financial intermediaries.

In late October 2015, the European Central Bank has published a Report on Financial Structures (RFS) 2015.

The RFS succeeds the Banking Structures Report (BSR) and covers the banking sector and other financial intermediaries, including insurance corporations and pension funds (ICPFs), as well as non-bank and non-insurance financial intermediaries.

Concerning interconnectedness across different parts of the financial sector, the report reveals that banks and other financial intermediaries (OFIs) are the largest holders of loans. OFIs are the largest counterparties.

For debt securities, banks are both the largest holders and the largest counterparties the research showed. Banks and ICPFs in the largest euro area economies are usually exposed primarily to banks and OFIs in their home countries with banks being especially prone to long-term debt, often issued domestically.

and a reduction in leverage ratios. More specifically, the median Tier 1 ratio increased to 14.4% in 2014 from 13.0% in 2013.

These developments confirm the trend towards a more traditional banking business model, but at the same time, several euro area countries need to take additional steps to combat the problem of increasing non-performing loans in to free up bank capital and boost credit expansion.

Assets of euro area ICPFs have increased steadily during recent years, with a strong concentration of total assets in a relatively small number of countries. Indeed, the high exposure to fixed income assets and the longterm nature of liabilities expose ICPFs to the current low yield environment. Also, the structural adjustment to the low yield environment is starting with diversification into non-life and asset management businesses, lower guaranteed rates on new policies and the use of interest rate derivatives. The profitability of the insurance sector has been con-

The on-going consolidation of the euro area banking system continued in 2014, indeed this rationalisation process resulted in an overall improvement of efficiency in the system. However, the total number of credit institutions decreased further to 5,614 in 2014, down from 6,054 in 2013 and 6,774 in 2008, although this is partly explained by a reclassification of credit institutions in one big euro area country. Also, total assets of the euro area banking sector stood at €28.1 trillion on a consolidated basis at the end of 2014, reflecting a decline of 15.7% compared with 2008.

Regarding banks’ liabilities and funding patterns, the gradual shift towards deposit funding came to a halt in 2014 and the use of wholesale funding stagnated in the same year.

Banks nevertheless continued to reduce their reliance on central bank funding and capital increases resulted in an increase in solvency

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strained by the low-yield environment and weak macroeconomic conditions. The solvency positions of the life and non-life insurance sectors are, however, well above the Solvency I requirements.

In terms of the euro area non-bank financial sector, frequently labelled the “shadow banking sector”, the analysis reveals that this sector has continued to grow over the past year, driven primarily by investment funds. Also, Euro area money market funds expanded as well in volume terms, following a protracted period of decline which began in March 2009.

By contrast, the number of euro area financial vehicle corporations has continued to decline over the past year owing to continued weak loan origination and securitisation activity by euro area credit institutions.

The report is available on the ECB’s website: www.ecb.europa.eu Source: European Central Bank

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Are Penny Blacks the New Pension Funds?

As investors seek diversification in their portfolios, rare tangible assets are becoming increasingly popular among those seeking diversification and long-term returns.

Following the 2008 global stock market crash, investors have become increasingly keen to diversify their portfolios away from traditional financial products. Recent global market instability has only increased this, with investors keen to ensure that they hold a variety of investment products in non-correlated areas in order to spread their risk.

This often means purchasing a number of products in a variety of asset classes, with tangible assets increasing in popularity because of their lack of correlation with financial markets.

Diversification in a portfolio made up entirely of financial product investments is difficult as they all relate to the market itself, which has led many investors to seek tangible asset investment as a means of ensuring that a proportion of their investment will remain viable in the event of further stock market problems.

houses and private sales. Because of the amount of information needed to compile these documents are issued annually, meaning the value of an item such as a rare stamp remains the same for a year, as opposed to stock values which are re-evaluated daily.

Keith Heddle, Investment Director at Stanley Gibbons, points out that although incorporating rare tangible assets is not a new phenomenon, its increased popularity highlights the growing need among investors to feel that at least a portion of their portfolio is stable.

“People have been storing money in collections of art, stamps or classic cars for centuries, but it is only more recently that we have seen a growing trend for investment in these assets.

The reason that investors are turning their attention towards tangible heritage assets is the lack of correlation with the finaical markets.

Increasingly, rare tangible assets are being used as the foundation for trust or pension funds, both because of their lack of correlation to the finaical market and their long-term appreciation, with many rare items such as stamps, old coins or fine wines requiring time to accumulate value with little depreciation, which is only seen through damage, unlike other tangible investments such as property or equipment which are easily damaged through use. Rare tangible assets tend to be collectable items which are displayed rather than used, and therefore damage to these items is limited.

Additionally, the value is often fluctuates less because it is based on indices from notable authorities on the asset in question, which are in turn based on reports from global auction 11 i-invest January 2016

“Unlike financial assets, rare tangible assets are not disposable, you cannot create and then destroy them to suit the market needs, as you can with shares. You cannot suddenly print anymore Penny Blacks because you want to use them in your fund, nor can you suddenly obliterate what is already available elsewhere in the market.”

He added that changes in the financial markets had been the catalyst to the shift in attitudes towards rare tangible assets as investments.

“Following the 2008 finaical crash, investors have found a new understanding in the term ‘diversity’. This no longer meant having a number of assets involving various financial products, because if the stock market crashed, all of these were affect.

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“Instead it now means holding a range of asset classes in each portfolio, so that when the market fluctuates some of its assets are not affected.”

As in any market, the demand for rare tangible investments changes regularly. Currently the market is geared towards demand as supply is limited, with the market being bolstered by international interest, which Keith believes is paving the way towards a shift in thinking from investors already working in the market.

“Rare tangible assets are governed mainly by supply and demand, with a current trend in collectors seeking to get the most value out of their collections and subsequently holding onto them, there is currently high demand in the market.

“Additionally, an emerging global middle class driven by economic improvement internationally has led to an increasing market for these assets.

“Trends such as these mean that there is an ever increasing need for investors in the UK market to view these changes on a global basis, rather than simply examining the market from a western perspective.”

Individual investors have often avoided investment in rare tangible assets because of the risk of forgery, damage to the asset or a lack of knowledge leading to imprudent purchases, but large investment institutions have the means to limit these risks, leading to an increase in interest among fund managers seeking diversified portfolios.

Ultimately, although limited resources and the long-term investment needed to ensure good returns makes rare tangible assets an unattractive choice for an entire portfolio, as an addition to a diverse portfolio they provide stability and separation from the fluctuating financial markets.

“There are currently over 20 million stamp collectors in China, as a result of the banning of stamp collection previously, which has led to many people attempting to reclaim their heritage through their collections. Other emerging markets such as India are also leading the way in collectable tangible assets, as an emerging middle class seeks to store its wealth outside of traditional investment options.

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% 16 10 p up eedrch 20 to rant st Ma a 31 gu

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The value of your investment can go down as well as up and you may not get back what you put in. Stamps and certain other collectibles are not designated investments for the purposes of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 and as such are not subject to regulation by the Financial Conduct Authority (FCA) or otherwise. Past performance or experience does not necessarily give a guide for the future. Minimum investment £10,000. Stanley Gibbons Investment does not provide valuations; please visit www.stanleygibbons.com for information on valuations, and investment. stanleygibbons.com for full terms and conditions. Please note: Past performance does not necessarily give a guide for the future.

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Investing in Emerging Market Equities: How to achieve double alpha Over three years ago, Milltrust International, launched a ‘double alpha’ EM product and now finds itself amongst the best performers in the emerging markets equity asset class for its GEMS multimanager portfolio.

There are two ways to make money when managing your investments in Emerging Markets equities, one, is by getting your stock selection right and, two, is by correctly managing your geographical exposure. If an investor is looking to maximize their returns in this asset class, they will need to exploit both of these sources of alpha. This is an incredible luxury that even developed market investors simply do not have as their investment universe tends to be more heavily influenced by bottom up factors.

There is so much disparity within the emerging markets universe which on the one hand further enhances the diversification and alpha-seeking potential within the asset class but on the other hand also questions the whole concept of the BRICS and GEMS buckets which are quickly becoming inappropriate. In fact, Goldman Sachs, who coined the term BRICS, recently closed down their BRICS strategy which has not gone unnoticed in the industry. The developing world has its commodity plays (Russia, Brazil), its high beta cyclical plays (Korea, Taiwan), its ‘Chindia’ play (China, India) as some investors call it which represents the urbanization theme, economic development and rising incomes. All of these investment buckets represent such vastly different market drivers that differentiating between them when investing is a no-brainer.

The whole concept of the BRICS and GEMS buckets which are quickly becoming inappropriate.

The bottom up approach to investing is certainly easier to grasp and less complicated as you are evaluating single businesses and the idea of appointing a locally-based manager with local

knowledge makes sense. The top down, on the other hand, appears more complex given the number of moving parts; however, simple adjustments can already go a long way.

Most investors tend to default to a market-cap weighted approach when considering their top down allocation despite the well known drawbacks of doing so. In the emerging markets the limitations of this approach are even more pronounced due to the significant divergence between the size of the market and the size of the economy. A large number of emerging markets still only represent less than 50% of their economy which is a reflection of the relative maturity (or immaturity) of each market and most importantly shows the future growth potential of that market. As an investor, you certainly want to be exposed to that future growth and definitely not constrained by unnecessary market-cap restrictions. These markets will also benefit as they open up, bringing with them a more diversified investor base and eventually lower volatility.

In fact, over the last decade, if an investor had followed a GDP-weighted approach to their top down allocation they would have significantly outperformed a market-weighted approach. This is not surprising given a GDP weighting is more of an active bet on the country and currency factors which matter for stock market returns.

This is just one example of using a top down factor, but it goes to show that even published GDP numbers can act as a better guide.

Besides growth, Milltrust extends its analysis to looking at demographic trends, political and financial risk, structural changes, as well as a country’s sensitivity to global macro risks. The geographical allocation models are built using a quantitative framework and z-scoring system to identify which economies are the more favourable for investment given the current environment.

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How much does this top down’ stuff matter?

Well, our own analysis and portfolio performance has shown that approximately 40% of the alpha can be attributed to top down factors. This is consistent with other industry studies.

The GEMS multi-manager portfolio is managed by the Milltrust Investment Solutions team led

by Eric Anderson and Alex Kalis.

Approximately 40% of the alpha can be attributed to top down factors.

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The Milltrust Geographical Allocation Models

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The New World of Operational Due Diligence Responding to a Regulated and Institutional Alternative Asset Industry

By Christopher Addy, CPA, CA, FCA, CFA速

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Alternative assets are now mainstream investments. Whether held through employee pension funds, accessed directly through traditional private partnerships, or increasingly offered through “liquid alts” mutual funds, virtually every investor has access to hedge funds, private equity funds, and other alternative strategies.

As the alternative asset industry has grown and matured, the discipline of operational due diligence (“ODD”) has become more prominent. Alternative asset investors no longer make decisions based on investment performance alone: allocators are focused equally on the risk of operational failure—be it through honest error or, in the worst case, through dishonesty and fraud.

Investors also recognize that weak business infrastructure creates an unavoidable drag on performance. An asset manager with weak controls will not have the data, technology, and operational efficiency to ensure optimal implementation of the investment strategy. For hedge funds in particular, operational effectiveness is paramount, given the high trading volumes and complex instruments included in many hedge fund portfolios.

Against this background, ODD, often an optional luxury before 2008, has become a mandatory component of alternative asset investing. Hedge funds and PE managers are no longer “different”, and institutional investors, often subject to fiduciary obligations, cannot accept lower operational standards simply because they are allocating to an alternative manager. As a result, it is becoming a baseline assumption that an alternative asset manager will match the operating standards and mitigate business risks in the same way as established, long-only money managers. ODD is the tool deployed by investors to ensure that alternative investment managers meet these evolving and more demanding requirements.

Enhancing the ODD Process In the context of a more sophisticated, institutional ODD agenda, investors continue to seek guidance as to implementation of a best practice operational due diligence program. Investors can consider a number of areas when enhancing their ODD programs.

Establish a Due Diligence Policy Managers and investors are familiar with compliance manuals, valuation policies, and disaster recovery plans, but the ODD policy as an additional governance document is a relatively new concept. However, a policy document should be the foundation of the ODD process, outlining clear procedures for initial operational diligence on new allocations and, thereafter, policies for the conduct of ongoing diligence on invested positions. A well drafted ODD policy will outline a risk-based ap-

proach, recognizing the different operational risk profiles of different types of investments (from long-only managed accounts, public and private pooled funds, hedge funds, private equity vehicles, etc.), and also take account of investment materiality. As a core concept, however, a threshold level of operational diligence should be completed on all third party asset managers, both when new managers are onboarded and then as part of an effective ongoing monitoring program.

Establish Responsibility for ODD as Part of Governance, Risk, and Compliance One of the key elements of the due diligence policy is to establish which functional area within an organization has responsibility for ODD. As ODD has gained importance and adoption, it has become firmly entrenched in the governance, risk, and compliance (GRC) agenda.

Placing ODD in the protective, risk-mitigating framework of GRC highlights, in particular, the need for segregation of duties between front and back office diligence. Given the evident conflict between market and business risk— what happens when a hedge fund has attractive returns but weak operational controls— ODD should not be performed by investment teams that are compensated for portfolio performance. The same conflict also impedes the ability of external investment consultants, who are equally focused on investment returns, to conduct effective operational diligence. ODD should instead be performed by risk specialists and report directly to GRC functional areas such as compliance, internal audit, and risk management.

Identify Operational Due Diligence Risk Areas ODD seeks to identify, manage, and mitigate non-market risk. In the world of alternative investments, this focuses on three primary categories: • the business risk of the management company (the entity responsible for investment decision making); • the legal risk of the fund entity (the product owned by the investor); and • the operational risk of the control environment (the controls and procedures in place to prevent fraud, theft of assets, and ensure that investment transactions are accurately recorded).

Specific areas that should be included in each operational diligence review include the following: 19 i-invest January 2016

• Security over the existence of assets. Diligence should identify and verify custodians, prime brokers, and derivative counterparties. Additional procedures are required for noncustodied assets such as private equity holdings and direct loans.

• Controls over cash movements. Investors should require asset managers to implement robust controls around transfers of client money held in funds and other client accounts. A single professional within the asset manager should not, for example, be able to disburse fund assets on his or her sole signature; rather client money controls should require dual signatories and a segregated prepare/approve/release procedure.

• Controls around asset valuation. Diligence should evaluate the fund’s valuation policy, the role of the valuation committee, and procedures adopted to ensure accurate valuation adopted by the investment manager, the fund administrator, and third-party valuation agents, if any. Extensive diligence attention should be given to illiquid, hard to value securities. The risk of deliberate misvaluation is clearly far greater with respect to assets that lack an active trading market and have no transparent, independent pricing sources. It is, however, typically these assets – which are precisely the securities most susceptible to deliberate mismarking – where administrators are typically ready to accept manager originated, rather than independently sourced, prices.

• Controls around trade capture and accounting. Internal to the manager organization, each asset manager should implement appropriate controls around trade execution, confirmation, settlement, and reconciliation. To the extent that mid- or back-office functions have been outsourced, investors should gain a thorough understanding of the responsibilities of external vendors and evaluate their resources, systems, and overall effectiveness.

• Service providers. Alternative asset funds may use external fund administrators, valuation agents, information technology providers, and compliance consultants.

Appointments should be verified, and the function and capability of each vendor evaluated. Issues such as legal and contractual liability should be considered. A recent trend, for example, is for fund administrators to seek to limit their liability even in the event of a loss to investors caused by their gross negligence.

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• Governance. The role of external fund directors should be examined using the “6 Cs” of governance—director and board competence, capacity, composition, choice, compensation, and control.1 Recent changes in the Cayman Islands have, for example, focused more attention on the role of external directors. This has resulted in positive trends for more-frequent board meetings and enhanced governance oversight.

• Compliance procedures. Given the new compliance paradigm faced by alternative asset managers, investors expect to see hedge and private equity managers appoint an experienced chief compliance officer (CCO), maintain robust compliance documentation, conduct frequent compliance training, and create an overall culture of compliance across the firm. The CCO often will be supported by a compliance consultant able to assist the asset manager with documentation, training, and services such as mock regulatory inspections.

Develop an Effective Reporting Process Even if the ODD process is effective in terms of gathering information and conducting diligence interviews with managers and service providers, findings and action points arising from the ODD process also must be documented. A consistent weakness of many ODD programs is poor documentation, with investors often struggling to keep reports up to date, or preparing only brief ODD documentation in the form of annotated questionnaires.

Effective reporting should, firstly, be consistent across all funds in a portfolio; thereafter, it should provide an overall assessment, highlight strengths and weaknesses, and identify action points and follow ups. Quality reporting evidences the investor’s diligence process (vital if the investor is itself subject to regulatory oversight) and supports ODD as an ongoing process of engagement and monitoring with each invested manager.

Develop an Effective Ongoing Monitoring Process ODD is not only a process conducted before investment. Post-investment diligence will, over the lifetime of an investment, require significantly more resources than the initial review when the manager is onboarded. Certain ongoing monitoring procedures likely will be annual, starting with annual updates to each diligence report and detailed review of annual fund financial statements. Intra year, many investors schedule diligence updates with invested managers, focused on issues such as changes in assets under management and product range, staff turnover, and any regulatory or other legal events. Investors typically monitor changes in counterparty composition and valuation profile intra year, with administrator transparency reports being an excellent tool to support monthly and quarterly oversight over these metrics. Investors should also complete real time monitoring to identify regulatory, news media (and increasingly social

media) commentary with respect to their asset managers.

The Way Forward: Embracing Operational Alpha Operational diligence is a challenging discipline. ODD requires significant resources, working within a well-defined process and methodology. In addition, investors increasingly will need to make investments in new technology solutions to streamline data-gathering and enable systematic identification and monitoring of operational risks.

Looking forward, investor ODD programs will continue to be driven by two motivations.

Firstly, many investors that are increasing allocations to alternative assets, such as corporate and public pension funds, operate within stringent fiduciary standards and are exposed to significant regulatory, business, and political risk. For this class of investor, the reputational and governance impact of investing in a hedge or private equity fund that suffers a loss due to operational failure likely will far exceed the impact of a loss solely due to investment underperformance.

More positively, as we have already discussed, investors recognize that operational quality will support investment outperformance, a concept that has been referred to as “operational alpha.” Other things being equal, it is reasonable to assume that, of two equivalently skilled investment professionals, the one supported by the more robust operational infrastructure will, over time, generate higher performance. This is the central value add of operational diligence, and it illustrates why more and more investors aspire toward top tier ODD. Christopher Addy, CPA, CA, FCA, CFA®, is president and chief executive officer of operational due diligence firm Castle Hall Alternatives. Castle Hall has been recognized as the “Best Global Due Diligence Firm” in both the 2015 and 2014 Alternative Investment Awards.

In addition to his work at Castle Hall, Chris is chair of the CFA Institute Capital Markets Policy Council and a founding member of the Executive Committee of the Fund Governance Association. Contact him at caddy@castlehallalternatives.com.

End Notes 1 Castle Hall Alternatives. 2013. Redefining Corporate Governance: Towards a New Framework for Hedge Fund Directors. https:// castlehallalternatives.com/wp-content/uploads/2013/12/201304-Redefining-Corp-GovernanceWeb.pdf.

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Magni Global While the origin of Responsible Investing dates as far back as the 1500’s, in the 1960’s the term Socially Responsible Investing (SRI) was adopted. In the late 1990’s, SRI began to incorporate other factors, including environmental, social, and corporate governance (ESG). The launch of the United Nation’s Principles of Responsible Investing (PRI) helped give rise to the term, Responsible Investing, which describes the process by which risk and return investors use ESG factors. PRI has around 1,200 signatories and those signatories now represent about 15% of the world’s investible assets1.

Many improvements have been incorporated into Responsible Investing. Initially, ethical portfolios tended to use negative screening (i.e., excluding companies). A whitepaper

by Deutsche Bank2 focused on studies of performance from negative screening. It documented that only 42% of these studies showed companies with high SRI scores as exhibiting outperformance. The whitepaper also found mixed results at the fund level.

Increasingly, there has been a shift from negative to positive screening (i.e., security selection and weighting based on adherence to a framework). The same whitepaper found overwhelming academic evidence that companies with high ESG scores have a lower cost of capital. It also documented meaningfully better performance from positive screening.

Within ESG ratings, the “G” had the strongest influence on performance3. Another study showed a strong positive relationship between corporate governance and company valuation4.

Specifically, strong shareholder rights have been found to increase corporate valuations5.

Board and audit committee independence better protect shareholder rights and help increase corporate valuations6.

By 2008 there were 11 providers of ESG ratings. An SSgA study found little consistent predictive power from these ratings, though the predictive power did strengthen over time7. A subsequent article8 explained some limitations in these ratings, including underdeveloped definitions, insufficient data, and untimely publishing.

Increasingly, the historical perception that Responsible Investing products deliver subpar performance is diminishing. Despite considerable progress, there is room for meaningful improvement. Further, given the demand for such products, there is significant room for product innovation to provide both better alignment with values and better prospects for attractive returns. In the not too distant future, Responsible Investing could become a proven source of alpha.

MSCI published an insightful study on the best practices in constructing Responsible Investing portfolios9. This study highlighted the need for a strong emphasis on corporate governance.

Countries can play a large role in improving corporate governance. This role includes strengthening the information reported by corporations, while also assuring common definitions. A report by the UNEP Finance Initiative10 specifically identifies a stronger role for governments in requiring more ESG information be reported. Fundamentally, corporate governance is significantly impacted by the requirements of the countries under which they are regulated11.

If two companies in different countries receive the same ESG score, the country can be the deciding factor regarding which company is a better investment. The company in the country with the better reporting requirements and where Responsible Investing is more important is more likely to further improve its ESG score. Incorporating country selection into investing can help identify where the greatest improvement is most likely. Country research may be the next major improvement to Responsible Investing.

A prior whitepaper by Magni Global Asset Management12 documents the current status of country research for investment purposes.

Researching country-level information has traditionally encountered significant challenges. The available information is mostly not standardized and is inherently qualitative.

Non-governmental organizations perform substantial research on countries, including economic performance and progress on social welfare. While such research is important and has many uses, it does not address the investment analysts’ need for frameworks containing available facts that yield clear overall 23 i-invest January 2016

pictures where countries can be compared on an “apples to apples” basis. This is not easily accomplished; if it were easy, analysts would already access such information.

Country scores are a Responsible Investing measure and have also demonstrated a correlation to investment performance. Decisions about Responsible Investing can be enriched through the incorporation of country scores.

The “G” in ESG has received less attention than the “E” and the “S”, yet it is more correlated with investment performance.

While the existing ESG measures have room for improvement, a better “G” can be used now.

Including the impact of countries on corporate governance strengthens the measurement of “G”, incorporates best practices, and positions portfolios for potential outperformance.

Kurt Lieberman Chief Executive Officer Magni Global Asset Management LLC 1

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“From SRI to ESG: The Changing World of Responsible Investing”, Caplan, Griswold, & Jarvis, Commonfund, 2013, page 3 “Sustainable Investing: Establishing Long-Term Value and Performance”, DB Climate Change Advisors of Deutsche Bank Group, June 2012, page 8 Ibid, page 54 “Corporate governance and firm value: International evidence”, Ammann, Oesch, & Schmid, Journal of Empirical Finance, 2010 “Corporate governance and equity prices”, Gompers, Ishii, & Metrick, Quarterly Journal of Economics, 2003 “Do US firms have the best corporate governance? A crosscountry examination of the relation between corporate governance and shareholder wealth”, Aggarwal, Erel, Stulz, & Williamson, National Bureau of Economic Research (NBER) Finance Working Paper, 2007 “A Comprehensive Analysis of the Relationship between ESG and Investment Returns”, Kennedy, Whiteoak & Ye, State Street Global Advisors, 2008 “The Future of ESG Investing” Ye, Taisheng, SSga Capital Insights, June 2012 “Optimizing Environmental, Social, and Governance Factors in Portfolio Construction: An Analysis of Three ESG-tilted Strategies”, Nagy, Cogan, & Sinnreich, MSCI Applied Research, 2013 “The Materiality of Social, Environmental and Corporate Governance Issues to Equity Pricing”, The United Nations Environment Programme Finance Initiative (UNEP FI) Asset Management Working Group (AMWG), June 2004 “Do US firms have the best corporate governance? A crosscountry examination of the relation between corporate governance and shareholder wealth”, Aggarwal, Erel, Stulz, & Williamson, National Bureau of Economic Research (NBER) Finance Working Paper, 2007 “Country Selection – A Powerful Technique of International Equity Investing”, Conant and Zimmer, Magni Global Asset Management LLC, www.magniglobal.com, August 2014, page 6

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Mexican Energy Industry Opening of Mexican Energy Industry Driving Energy Infrastructure Investment and Breathing New Life into Petrochemicals, IHS Says.

Access to abundant U.S. natural gas via pipeline driving investment on Texas-Mexico border, fuelling opportunities for midstream, power generation and petrochemicals.

The recent opening of the Mexican upstream energy industry, combined with access to abundant U.S. natural gas feedstock from Texas, is driving significant energy infrastructure investment on both sides of the border. That infrastructure, along with planned access to more competitively priced electricity promised by the reforms, is breathing potential for new life into the Mexican petrochemical industry, which has long relied on imports to meet its domestic needs, according to new analysis from IHS, the leading global source of critical information and insight.

“After 15 years of stagnation, with no new petrochemical production capacity installed in the country and several plant closures, the Mexican petrochemical industry has been overdue for investment and has had to rely heavily on raw material imports to meet its need for local production of many chemicals,” said Rina Quijada, Ph.D., senior director, Latin America, at IHS Chemical. “In 2014, Mexico imported nearly U.S. $24.5 billion in chemicals and petrochemicals to meet its domestic needs, according to ANIQ, Mexico’s petrochemical industry association. However, for some chemical value chains, such as polyethylene, the import gap is more dramatic. Last year, Mexico had to import approximately 1.5mn tons of this widely used plastic, which is about 75 percent of the country’s polyethylene demand,” she said.

Quijada said that new production capacity is expected to start up by the end of 2015, reducing import demand for PE in 2016. That ethylene/ polyethylene project, which is a joint venture effort between Brazilian-based Braskem and Mexican-based IDESA, is located in the state of Veracruz, and will use ethane as feedstock.

“This new site should be highly competitive,” Quijada said. “Mexico needs more of this type investment, and we at IHS Chemical anticipate

growth in production capacity of petrochemicals once additional feedstock is available in the next five to eight years.”

The changes in Mexico’s energy policy are already driving private investment in the energy infrastructure necessary to transport U.S. natural gas to Mexico,” Quijada said.

“For Mexico, that gas means access to abundant, competitively priced feedstocks for petrochemical production. Just as important, it can be used for production of reliable, costcompetitive electricity, which is absolutely essential to grow the entire manufacturing base in the country and to making Mexican petrochemical production cost competitive.”

Mexican energy reform is driving billions of dollars in planned midstream investment, as private and state-owned companies seek access to abundant natural gas production available from key U.S. energy plays, including the Texas powerhouse known as the Eagle Ford shale, which extends from South Texas into Mexico.

The Los Ramones (Phase I) pipeline, which came online last December, added an impressive 2.1 billion cubic feet (BCF) of natural gas per day of import capacity from Texas. Additional projects totaling 3.45 BCF per day of cross-border natural gas capacity are under development, and once online, will significantly increase gas availability in Mexico.

“These pipeline investments are needed to connect the regions that don’t currently have access to natural gas,” said David Crisostomo, a natural gas and power analyst at IHS Energy.

“As a result, fuel-oil generation is still being used in regions such as the northwest, which is more costly than gas. This means Mexican consumers and manufacturers pay more for electricity when compared to their U.S. neighbors. Access to more affordable power

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will not only enable the petrochemical industry to grow and flourish, but also many other industries, such as automotive and consumer goods production,” he said. “The process will take some time, but the impacts for the Mexican petrochemical industry, the manufacturing base, and the economy, will be positive, and the power sector is pivotal to this success.”

The chemical industry is very important for Mexico’s economy and the country currently relies heavily on imports to meet its need for many chemicals. In 2014, it accounted for close to 12% of manufacturing, according to the National Institute of Statistics and Geography (INEGI). However, manufacturing growth in Mexico is hampered by a lack of reliable supply of competitively priced electricity necessary for manufacturers to add production capacity in the country.

According to IHS Energy, Mexico has the third highest amount of oil reserves in Latin America, relevant natural gas reserves, and in 2013, was ranked number 10 on the list of the top hosts of foreign direct investment inflow by the UN Conference on Trade and Development.

However, the absence of relevant investment in petrochemicals has caused Mexican production figures to grow just marginally during the last couple of decades, while imports of chemicals have grown steadily.

“This lack of investment in the petrochemicals sector is due, in part, to two key challenges faced in the past by the national oil company Petroleos Mexicanos (PEMEX),” said Raul Alvarez, a consultant with IHS Chemical. “First, significant fiscal burdens were imposed on the company, which severely hampered PEMEX’s ability to invest in major downstream projects outside of E&P. Second, the resulting lack of economic and technical resources in Mexico led

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to the company’s unsuccessful efforts to reverse a steady decline in oil production, which peaked in 2004, and meant it was unable to develop its most promising hydrocarbon basins.”

Consequently, for a long time with few exceptions, (such as Braskem/IDESA’s ethylene and polyethylene project), Alvarez said, PEMEX has been unable to engage in long term, competitive feedstock/basic petrochemicals supply commitments for petrochemical projects.

Trade statistics show that organic chemicals are the most important group of chemicals being imported by Mexico (organics account for close to 85 percent of total chemical imports), and capacity gaps exist today across and along diverse petrochemical value chains.

Styrene, paraxylene and cyclohexane are just three examples of petrochemicals that Mexico demands and imports in significant quantities.

The list goes on further downstream, as demonstrated by imports of plastic resins, such as polymers of ethylene, polymers of propylene, polymers of vinyl chloride and engineering plastics. The irony that such capacity gaps

often pose can be further illustrated by using styrenics as an example: In the mid-1990’s, production of consumer products, appliances, automotive parts and food packaging products for local consumption and exports was booming in Mexico, according to IHS. As a result, significant capacity for the production of polystyrene (PS), acrylonitrile-butadienestyrene (ABS), expandable polystyrene (EPS) and styrenic elastomers was installed in the country.

The resulting total demand for styrene, the main raw material required by these new plants, greatly exceeded the local supply, forcing the project owners to import the balance.

“Regarding trade,” Quijada said, “the Mexican petrochemical industry is increasingly in a trade deficit because domestic demand is growing, but insufficient local production capacity is being added to meet demand. While changes are already under way, we should see significant progress for petrochemical expansion after 2018, when the impacts of Mexico’s energy reform truly begin to help the country’s petrochemical business grow,” Quijada said.

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Quijada will join other chemical, energy and economic experts from IHS, along with industry leaders to discuss a host of topics, including the implications of energy reform on the Mexican petrochemical industry, along with other market dynamics such as the crude oil price volatility and its impacts on the industry and region, at the Latin American Petrochemical and Polymers Conference (LAPPC), scheduled for November 7, in Cancun, prior to annual APLA meeting.

“For Mexico, that gas means access to abundant, competitively priced feedstocks for petrochemical production.

Just as important, it can be used for production of reliable, cost-competitive electricity, which is absolutely essential to grow the entire manufacturing base in the country and to making Mexican petrochemical production cost competitive.”

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The Impact of Mifid II on the Anatomy of an Investment

By Gary Stone, Chief Strategy Officer for Bloomberg Trading Solutions

As market participants start to work their way through ESMA’s MiFID II implementation standards, a framework that could help clarify how the regulation is going to affect the investment life cycle on the buy side is emerging.

Structuring the different requirements of the regulation is extremely important, because at 585 pages for the regulatory technical and implementing standards alone (Annex I), MiFID II is an expansive document.

And more is coming as ESMA is expected to provide additional insight into the use of dealing commission, fixed income research and other areas.

The anatomy of an investment An investment can be segmented into eight functional activity groups. Pre-trade activity provides information to form an investment thesis. Trading involves order management functionality for timely and efficient execution. Trade management activity allows for straight-through processing and timely allocations and operations activities cover the booking, settlement and fund transfer process, as well as the post trade regulatory arrangements.

Furthermore, within each of the functional activity groups, there are defined activities that constitute the end-to-end investment process, or workflow. It is against that backdrop — when we overlay the MiFID II changes — that the buy side can start to identify where their world will be changed.

The three pillars of MiFID II At a high level, MiFID II can be seen as resting upon three core pillars: 1. Best execution, information to clients and surveillance; 2. Monitoring, limits and controls; and 3. Regulatory reporting and transparency.

When you break down these pillars into functional requirements, you see the regulation touching many of the workflows of an asset manager, at all stages in the trade life cycle Pre-trade Approved Publication Arrangements (APAs) will provide pre-trade transparency publications and post-trade publishing of trade information. Although ESMA is labelling assets as liquid or illiquid under MiFID II, each investment firm should use quantitative metrics to better understand the assets that they are placing in their portfolios.

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“Asset quality” quantitative metrics also require firms to identify the highly liquid assets in their portfolio to help them pro-actively manage their liquidity (redemptions).

This isn’t solely a MiFID II issue. The principles behind the U.S. SEC’s proposal on fund liquidity are very similar.

Guidance is also needed as to whether the clock synchronisation requirements extend into the order creation process for transaction cost analysis.

Moreover, market participants are waiting for the dealing commission guidance, which may result in new compliance requirements for research and execution payments. For example, they might have to set up independent budgets for research and execution, coupled with appropriate best execution measures to demonstrate that such budgets are arrived at independently.

Trading MiFID II is very prescriptive on how investment firms should execute and there is tremendous concern about information leakage from the new pre-trade transparency requirements as well as the post-trade reporting.

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If buy side firms become members of MTFs or trading venues, they will need to institute new monitoring, limits and controls processes as well as technology in accordance with the new direct electronic access (DEA) pretrade controls requirements.

Moreover, MiFID II may result in more execution method choices, competition among venues, fragmentation of liquidity and order types — all of which will need to be stitched together. The regulation will also force a new regulatory workflow.

The right framework MiFID II is an expansive regulation that will impact the full life cycle of the trading process, bringing greater transparency at all stages. For firms who do not have the right framework in place it will be a bigger challenge and potentially more costly to implement. As market participants work through the technical standards and receive guidance from the various European National Competent Authorities, this framework will naturally continue to be expanded upon.

Operations New post-trade compliance processes will need to be created to deal with enhanced transaction reporting requirements through and Approved Reporting Mechanism (ARM), as well as the need for trade surveillance. In addition, firms outsourcing their trading and order management technology may need to develop new policies to supervise and govern their technology partners.

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By Henry Tapper. Henry is Founding Editor of Pension PlayPen and Director of First Actuarial

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How bosses can help their staff get more from their DC pots!

Yesterday I had a chance to talk with a large employer about what they can do to help improve the outcomes of their DC plans.

Pension Regulator’s “engage, educate and empower” campaign to keep members away from scammers.

running schemes would be able to do this work for themselves , through governance committees or trust boards.

Influencing employees to get the best out of their pension savings means getting them to engage with the need to save, educate about how to save and empower them to get on with their plan.

Face to face is best In the past, we lumped all the above into a useless term “scheme communications” which generally consigned “engagement, education and empowerment” to a brochure that got flung in the bin along with all the other pension literature that comes a member’s way.

The Pensions Regulator now recognises this hope as forlorn. The OFT report confirmed what most of us already knew, that understanding value for money, creating structures to help people spend their savings and overseeing the administration of DC schemes are duties beyond all but a handful of employers.

Making sure that members get the most out of the contribution structure the employer’s put in place, make suitable investment decisions and spend their savings sensibly is something an employer can do.

Many employers are waking up to the fact that you can really only get a member’s attention by getting them out of the day to day routine, in a room, with someone who knows what they’re talking about.

This level of governance has been largely outsourced to “master-trustees” and Independent Governance Committees” who do the day-today job on behalf of employers. But this does not mean the employer should be complacent.

In fact it can be considerably cheaper and more effective to help employees do this for themselves, than simply throwing money at the contribution rate.

Our experience shows that there is no substitute for doing this- not fancy brochures, or videos or interactive games that sit on tablets or phones. Until you have got people’s attention, the rest is useless.

Employers still have a duty to choose the pension provider, this is a duty under auto-enrolment and it is not just a fluffy duty of care.

Give the man a fish and you feed him for a day, teach the man to fish and you feed him for ever.

When you look at the Pension Regulator’s 6 outcomes of good DC governance, you discover that half relate to helping members make better decision.

I’ve highlighted them Appropriate decisions with regards pension contributions.

Appropriate investment decisions.

Efficient and effective administration of DC schemes.

Protection of scheme assets.

Value for money.

Appropriate decisions on converting pension savings into a retirement income.

I used to think that “protection of scheme assets”, related to trustee negligence (oops – where did I put those units) but recent events have proved that trustees and governance committees have a duty to protect members from themselves – this is the thrust of the

The platform on which you build Fan as I am of face to face financial education, it can only be provided where the foundations of the saving- the savings plan – are properly constructed. Let’s look again at those six good DC outcomes Appropriate decisions with regards pension contributions.

Appropriate investment decisions.

Efficient and effective administration of DC schemes.

Protection of scheme assets.

Value for money.

Appropriate decisions on converting pension savings into a retirement income.

This time I’ve highlighted what an employer can do to improve outcomes behind the scenes.

This is all about taking care with the selection of provider and the management of that provider to make sure they do the business!

When this list was compiled in 2011, the Pensions Regulator still hoped that employers 31 i-invest January 2016

Getting the wrong provider could result in a suit of negligence from members, wilful choice of an inadequate or even a fraudulent provider could lead to proceedings initiated by the Pensions Regulator and followed up by criminal prosecution.

It is not just a duty at outset, every time that an employer is sending money to a workplace pension provider, they are validating that initial decision. Obviously , it is not pragmatic to conduct due diligence on a monthly or even weekly cycle, but it really is down to the employer to make sure that a decision made when staging auto-enrolment, remains valid in years and decades to come.

Live the dream - every employer should!

It is all too easy for employers to say this is beyond them, for many employers it will be, many more could bother but won’t. But if you are working for, or are the owner of an employer who has or is about to have a workplace pension, then you would be wise to make the most of it. For the sake of your staff, staff morale, productivity and ultimately the value of your business, it is worth paying attention to these issues.

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Sustainable Food Supply Chain Many companies in the food industry are under pressure from weak consumer spending, currency headwinds and activist investors focused on the short-term. The industry is re-sponding with severe cost cutting and increased merger and acquisition activity, such as the recently announced HJ Heinz and Kraft Foods mega merger. These developments put a lot of strain on supply chains at a time when the industry may well be overlooking the more important strategic need for meaningful investments in organic and natural food supply chain capabilities.

Today’s consumers (especially the younger generations) demand healthier food choices and more natural ingredients, shunning high volume, wellknown iconic food brands. Consumers are more inter-ested in knowing where their food originated, the ingredients within food and how food is produced with sustainable methods. Well known producers, food service providers and suppliers such as Her-shey, Nestlé, McDonalds, Tyson Foods, Costco, Yum Brands and others have all embarked on initia-tives directed at curbing the use of antibiotics in animals, artificial food colouring, and higher quality standards for suppliers. The strong demand growth for healthy and natural food impacts the whole food supply chain.

(livestock). The different inputs are processed in successive stages and to different degrees, packaged and dispatched to customers (e.g. distributors, food service). Another important activity of food manufacturers is to carry out market and product research leading to the development of new products, and to engage in marketing. The distribution sector (and retail in particular) is the principal outlet for food products and, being the final link in the supply chain, it interacts directly with final consumers.

While the sector’s main activity is the sale of products, in doing so, retailers may also carry out services for food manufacturers, such as promotional activities.

Food supply chain The food supply chain connects three main sectors (see figure below): the agricultural sector, the food processing industry and the distribution sectors (wholesale and retail). Basic agricultural commodities undergo, to varying degrees, an often substantial series of intermediate alterations before they are sold as final food products to consumers.

The first sector considered in the food supply chain is the agricultural sector. Its activities include crop production and the raising of livestock. As agricultural commodities comprise of very different prod-ucts, the sector’s distribution channels are equally diverse. Firms in the agricultural sector primarily sell their output to the food processing industry. The food processing industry is very heterogeneous and comprises of a number of varied activities. These include for example refining (sugar), milling (cereals), cleaning, cutting or drying (fruit and vegetables) and slaughtering and disassembling 33 i-invest January 2016

Supply side struggles to keep up with demand In the light of ever increasing consumer demand for more organic and sustainable food products, food producers need to focus on increased product innovation and quicker introduction of new and health-ier products. The biggest impact of these changes will be especially felt by the suppliers, which face limits to how fast they can ramp up production of natural, and especially organic ingredients A recent article published by The Wall Street Journal, Hunger for Organic Foods Stretches the Supply Chain, described this phenomenon.

According to the report, the increasing need among consumers for more organic foods is literally causing problems for suppliers to keep

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up with demand. A major driver for this is that farmers, dairies and ranchers face significant costs and risks in attempting to con-vert from conventional to organic farming or animal production techniques. “While organic produce or livestock can command prices as high as three to four times that of conventional food, farmers gener-ally have to sell their food at conventional prices during the transition.” This effect can potentially limit the supply of natural and organic ingredients, making the transition of the value chain towards healthi-er food difficult.

Collaboration between suppliers and food processors Fortunately there are companies which are willing to invest in a more sustainable supply chain. Organic and natural foods producer Hain Celestial Group, soup maker Pacific Foods and fast casual restaurant chain Chipotle Mexican Grill are recruiting, financing and training more farmers willing to utilize and adhere to organic methods. Some producers such as Hain Celestial have had to initiate long-term buy-ing agreements, as much as three to five years, to insure the transition to more organic supplies.

Two years ago, Chipotle began providing financing incentives to help black bean farmer’s transition from conventional to organic production. This fast-growing restaurant chain that prides itself on higher qual-ity, ethically based food ingredients recently took the bold step of suspending sales of its pork prod-ucts in nearly a third of its restaurants after discovering a supplier was not complying with animal wel-fare standards.

Unfortunately, when a farm decides to convert to organic or natural products, the transition isn’t sim-ple or instantaneous. It varies slightly depending on the certification needs, but typically farms must: • Adopt new farming methods and processes • Farm on the previously conventional soil for a longer period of time • Have periodic, comprehensive inspections by third-party agencies In case a farm has been certified organic (which is much more strict than natural), it requires ongoing inspections from a third party to ensure its land and produce continue to meet organic standards.

Food processors are changing Besides the challenges on the supply of healthy ingredients, food manufacturers also have to rethink how they develop and produce food.

One important change is to alter recipes by eliminating high calo-rie ingredients like high fructose corn syrup and artificial colours and flavours. For large companies, developing new products has become very challenging due to the rapid development of the market for healthy food. The CEO of US food manufacturer General Mills explains: “We’ve changed how we do new products quite a bit. We used to do fairly large-scale sequential testing, often administered by third parties, so our marketers were reading lots of data and numbers. We’ve looked at how small companies are developing their new products, because they seem to go fast, and are very different than us. We are much closer to the consumer now. When the development team has something they think is pretty good, they now take it to a store or somewhere else and actually sell it themselves. They are very close to what’s actually happening out there, and are getting direct feedback. What we actually call it is setting up a “lemonade stand.”

Natural food retailing In the past couple of years the growth of specialized retailers of healthy food products has been spec-tacular. The most important examples have been Sprouts Farmers Market and Whole Foods. As the category is young and still relatively small, natural/organic food products are not as dominant as the large national brands are in traditional foods. This enabled large supermarket chains like Kroger to build up its own range of natural/organic products very quickly and realize a similar market share as the spe-cialists. Conventional retailers have now even overtaken natural product retailer’s sales growth rate.

Consumer surveys also suggest that over 75% of current natural food consumers have a strong prefer-ence to purchase their natural products through a conventional supermarket. As a result, over the long term, traditional supermarkets will likely be the largest sellers of natural and organic products.

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How do we play this theme?

The shift in consumer demand towards natural and organic food is likely to severely impact supply chains across the food industry in the coming years. This creates multiple opportunities for investors. The investment opportunities are however not evenly spread across the supply chain. We already see that specialized organic/natural food retailers are losing their first mover advantage to traditional food retailers who have rapidly adjusted their assortment to cater their customers’ needs. Given that food retailing remains a very competitive, low margin business, we are not surprised to see growth rates are already starting to disappoint due to increasing competition. As a result we do not regard the ex-pensive shares in pure organic/ natural food retailers as an attractive investment.

Suppliers to the food processing companies are a more interesting area to invest in. In this segment we have a preference for specialized niches. A big part of the volume of goods traded in this sector can be classified as bulk ingredients such as wheat, corn, sugar, and cocoa. The operating margins in these commodities are typically below 10% due to the commoditized nature of these products. As a result we have a preference for names in the specialty food ingredients, which are key determinants of the taste and appearance of the end-product. Barriers to entry in this segment are typically higher.

Be-cause of the importance and the complexity of these ingredients operating margins in the specialty segment are more attractive and usually higher than 10%.

Jeroen Brand, Client Portfolio Manager, Senior Portfolio Manager Sector Funds, Industrials, Technol-ogy & Telecom at NN Investment Partners

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Pensions in Europe The basic purpose of pension systems is to deliver adequate retirement incomes and to allow older people to enjoy decent living standards and economic independence. However, the ageing population presents a major challenge to pensions in Europe. Longevity growth, declining birth rates and the transition into retirement of the baby-boomers will have farreaching economic and budgetary consequences on public finances in the EU. The challenge is very much upon us. All Member States with pay-as-you-go systems are, as a result, confronted with big increases in costs, which means a growing pressure on solidarity and a heavy burden on the public finances and on the younger generation. It is important to find solutions today for the retirement challenges of tomorrow. Pension systems vary widely across Europe. In many Member States reforms have already been implemented in order to keep pensions sustainable, but more needs to be done to tackle the consequences of the ageing of our populations. Raising the retirement age and getting more people at work would reduce the pressure on social security and therefore the budget deficit. But what is also needed is more capital funded pension systems across Europe.

In Member States where employees have access to an occupational pension scheme, the demographic problem is less urgent. There is a need for better coverage of and access to occupational retirement savings, in which workplace pension schemes play the most important role. We believe that the development of workplace pensions should be given priority in developing supplementary retirement savings. Workplace pensions are more cost-efficient in comparison with personal pension products as they benefit from the fact they are often based on collective agreements and are not for profit. Workrelated pensions also benefit from enhanced governance structures, with the active involvement of main stakeholders and social partners, thus facilitating the alignment of interests and eliminating possible agency problems. For instance, in some countries the sponsoring employer has obligation to ensure that the pension promise they made is finally met. This provides additional protection to the members and beneficiaries of occupational pension. It is therefore necessary to recognise the important role of workplace pensions and their provision should be strengthened.

Member States have used different practices or combinations of them to increase coverage of workplace pensions: compulsion, auto-enrolment, tax facilitation, collective bargaining, incentives for employers etc. If done so, workplace pensions can provide an effective means of achieving high participation in retirement savings among groups of people, who would otherwise be unlikely to save or to save enough for a comfortable retirement.

Challenges and developments The last decades the pension landscape in Europe has experienced a tremendous transformation from Defined Benefit (DB) schemes based on final pay to all sort of different hybrid Defined Benefit schemes or Defined Contribution (DC) schemes. The reasons for such developments can be found in the demographic development, but also in the changes in the labor markets with more mobile people, accounting rules and increased costs for the sponsors that make it more difficult for employers to provide for a DB pension. Both DB and DC schemes face challenges though, especially the current monetary environment poses a challenge for pension funds. Monetary policy (including Quantitative Easing) has triggered the lowering of interest rates to ultralow or negative levels, with consequences for both DB and DC schemes. The low interest rate environment put pressure on investment returns and especially increased the value of the liabilities when discount rates are based on market rates.

Pension funds need economic growth and better returns to be able to provide for good pensions. Economic growth could be restored, amongst others, by capital markets fulfilling the financing needs of companies.

Pension providers, as long-term institutional investors, are well-suited to take up this role, provided that all required conditions are met for sound investment decisions and that no other constraints, for instance unnecessary regulatory restrictions are imposed. If so, pension funds can contribute to financial stability in Europe and are able to provide European companies access to capital. It should be stressed though that pension funds invest for their beneficiaries, namely current and future pensioners. Investments have to be in line with their interests and the objectives of the fund. Traditionally, pension funds invest a substantial part of their portfolio in bonds.

But, the current monetary policy incentivizes 37 i-invest January 2016

pension funds to explore alternative investments that provide greater returns (through capital markets: e.g. infrastructure, private equity and private real estate). These investment categories bring additional challenges as well: in terms of capacity (experience), level of risk as well as higher costs. While in recent years some pension funds have acquired in-house capacity for infrastructure investment, especially small and medium sizes pension funds face a challenge as they lack the expertise necessary when dealing with such investments.

Personal pensions To get Europe growing again by channeling more savings into the economy and to get more people to save for retirement, the European Commission asked EIOPA to work on a Pan-European Personal Pension product (PEPP). PensionsEurope believes that while social security and workplace pensions do and should continue to provide the bulk of the retirement income, voluntary personal pensions can be needed and useful, especially to provide pensions for those who don’t have access to adequate workplace pensions and as a further way to improve retirement resources and contribute to securing the future adequacy and sustainability of pensions. Therefore, we believe that the PEPP may improve supplementary retirement savings, especially in Member States where there is, unfortunately, limited workplace pension coverage. But defining the scope of the PEPP Project is very important: it should not undermine the development end enhancement of workplace pensions in the EU. Matti Leppälä Secretary General , CEO PensionsEurope www.pensionseurope.eu

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Ethical Investments Since the early 1980s, ethical investment has been a niche, but growing part of the UK investment landscape. Latest figures from EIRIS, the UK based research provider, puts the combined assets under management in UK retail ethical products at June 2014 at £13.4bn invested in over 80 UK domiciled green or ethical products. These provide a rich base for any responsible investor choosing to invest their money, be it using conventional ‘negative’ screened criteria, or applying positive sustainable criteria or themes such as clean technology, water and climate change.

Institutionally, the picture is even more encouraging. Changes over time in regulation and legislation have had a material impact on thinking by pension funds and charities. As long ago as 2000, a change in occupational pensions legislation resulted in Trustees having to disclose how, if at all, they take material environmental, social and governance (ESG) risks into account when making or retaining investments. This change was swiftly followed by the Charity Commission amending its guidance to suggest that applying an ethical investment policy is wholly admissible, if not to do so would lead to reputational damage or a withholding of funds by donors. The recent review of Fiduciary Duty by the UK Law Commission essentially aligned itself with these now well-established positions.

As the world faces up to the increasing challenges of climate change, human rights violations in corporate supply chains, environmental damage and resource depletion, investors have come to see that embedded ESG risk may have a material impact on their long-term investments. The sometimes noisy debate on fossil fuel divestment and ‘stranded assets’ is one such proxy for how these debates gather momentum and capture international attention. Many high-profile faith and charity investors have endorsed a gradual withdrawal from high-impact fossil fuel investment such as oil sands and thermal coal on the back of perceived embedded risk to their long-term prospects. Eurosif, in its annual study of the European Socially Responsible Investment (SRI) market, assessed that in 2014 investors from 13 distinct European markets had deployed trillions of Euros across eight SRI

strategies, ranging from pure exclusion, to thematic through to screening against international ‘norms’. Across all distinct strategies there was one consistent emerging from the Eurosif analysis – there was sustained growth in capital deployed across all sectors.

The UK remains Europe’s largest and most developed market for responsible finance with traditionally, strong support from government and regulators. This however begs a question: how is this growth supported through robust research?

The question is vital if the responsible investment industry is to maintain trust, respect and integrity. First, it is supported by strong intellectual support from the NGO and academic communities. The former have driven thinking for stronger protocols around carbon pricing, emissions disclosure, human rights metrics and water impact.

The latter is represented by over 1,200 postgraduate courses in relevant disciplines that impact thinking and behaviour. There is the benign regulatory and legal framework that has supported enhanced disclosure and analysis to help investors correlate their judgements across businesses and industry sectors; a binding vote on executive pay and greater disclosure on Board dynamics has enhanced the corporate governance landscape as well. A focus on sustainability as part of ‘risk management’ has helped drive a greater appreciation of the contribution ‘non-financial’ risk can make as part of any investment strategy, to the extent that more managers, at least anecdotally, are beginning to ‘integrate’ the dynamics of ESG risk into mainstream investment research. But how can we be reliably sure this is happening?

The first way is via the UK Stewardship Code which is promoted by the UK Financial Reporting Council. Introduced in 2010, this is now supported by over 200 Fund Management Houses and 80 Asset Owners, each committing to the Code’s seven Principles of more effective stewardship. Secondly, the UN Principles of Responsible Investment has attracted over 120 Fund Management Houses in the UK supporting the six Principles which recognise the long-term performance of investment portfolios can be affected by material ESG factors, and that aligning with the Principles may also better align the interests of investors 39 i-invest January 2016

with those of society – in many instances public funds managed in the name of societal beneficiaries. The PRI, created only a decade ago, has achieved extraordinary traction with over 900 investment managers and nearly 300 asset owner signatories in total.

This represents a substantial body of support for the integration of responsible investment

by Fund Managers, which appears to be happening in a more structured and routine way. However, it still requires thorough interpretation and analysis in order to come to balanced and informed decisions.

Fund Managers have typically employed dedicated expertise to help with their integration strategy. Industry best practice would be to have a team sitting alongside Fund Managers, who assess, screen, engage and vote on the companies held within their portfolios.

This team would also develop policy, and lead public policy advocacy where this adds value for clients. This provides firms with additional tools such as: •

Service providers: these conduct the basic raw data research on a universe typically covering the world’s leading indices of around 3,500 companies. The two global leaders in this space help investors’ assess material ESG risk, provide recent controversies updates and provide absolute and peer and group rankings.

•

The NGO community has led initiatives allowing investors to understand how companies are performing with regard to specific impact areas. These are used as a tool for further engagement or as a way of potential screening. Examples include –

• •

Access to Nutrition Index Extractives Industry Transparency Index Business Benchmark on Farm Animal Welfare CDP Water Survey

• • •

Arguably the most successful of these many initiatives has been the Carbon Disclosure Project (CDP). Working with 3,000 global corporations and supported by 822 global investment institutions, the CDP has become the world’s

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largest repository of GHG (greenhouse gas) disclosures which can be used by investors to assess climate change risk and intensity. The initiative has also furthered the trend towards portfolio foot-printing, whereby the carbon intensity of a Fund can be measured and assessed.

•

Access to databases of organisations such as Transparency International and Freedom House to assess human capital or supply chain risk, where labour issues demand ever more vigilance.

House policies for the screening, monitoring, sale or retention of investments in responsible fund portfolios should be assessed across all these various providers, data sets, initiatives and rankings. This builds into a substantial body of integrated information allowing us to make

quantitative and qualitative decisions about the inclusion (or exclusion) of stocks from the Funds.

Investors are fortunate: trends are firmly towards more and better disclosure providing investors with a rich stream of data to mine.

Fifteen years ago, responsible investment was relatively unsophisticated based on poor overall and inconsistent disclosure. Companies internationally are more comfortable with reporting as the world wakes up to the complexity of sustainability risk. However, this will inevitably require greater skill in the way analysis is gathered and deployed, requiring in turn more investment dedicated to core SRI strategies and capabilities.

Neville White, Head of SRI Policy & Research at EdenTree Investment Management Ltd. 8 September 2015

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“A focus on sustainability as part of ‘risk management’ has helped drive a greater appreciation of the contribution ‘non-financial’ risk can make as part of any investment strategy, to the extent that more managers, at least anecdotally, are beginning to ‘integrate’ the dynamics of ESG risk into mainstream investment research. But how can we be reliably sure this is happening?”

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Pension Reform From DB to DC New era of pensions The budget reforms of April 2015 brought an overhaul of the pensions system not seen in a century. The uniformity of annuitised retirement solutions has been replaced with choices and greater flexibility over how to take income during your retirement. Consequently, financial advisers have seen a surge in demand from clients to review their pension pots. Research by True Potential revealed consumer demand for financial advisers increased by 66% since April 2015, with energised consumers increasingly demanding advice over the options newly available to them.

The small print with DB schemes However, members of defined-benefit (DB) pension schemes are unable to access these new freedoms. If they wanted to directly take advantage of the new flexibilities, they will have to transfer out of a DB scheme to do so. DB schemes conventionally pay out a guaranteed percentage of salary each year during retirement and have long been the most coveted of pensions. Though transferring out holds the key to accessing the freedoms, it isn’t always in a prospective retiree’s best interest. These gold plated pensions are considered the Rolls-Royce pension product, offering guaranteed, inflation-proofed income, which continues to pay to a spouse after your death.

Growth in popularity of DC schemes With a Defined Contribution (DC) pension, people are given the flexibility to do a multitude of things with their pension, in a way that suits their particular lifestyle. Aside from the flexibility to take out their pension cash as they would like, members are able to make as little, or as many contributions towards their pot as they would wish. They also have the ability to withdraw as much cash from their pot from the age of 55 as they desire, although there are tax implications if they withdraw more than the tax free lump sum allowance.

This type of scheme has become more popular among employers, particularly smaller firms,

due to their lower cost. A DC scheme works by the employer and employee agreeing on a set percent amount to be contributed to an individual pension fund. Unlike DB pension schemes, however, the level of retirement income for the member is not guaranteed.

The tide swings from DB to DC Policy makers were bearish on the consumer loyalty to DB schemes even before the freedoms had time to make an impact. In setting out the reforms, the Financial Conduct Authority estimated that the freedoms could lead to an extra 9,000 to 15,000 DB to DC transfers annually. Looking at this retrospectively, we can see this forecast was not without some merit. Selectapension, has seen over twice as many people (+142%) looking to review their DB scheme in the six-month period following the introduction of pension freedoms, compared to the same period a year ago. The system data showed this was most common among the over-50 group, with DB reviews for those over 50 in 2014 (59%) spiking to 78% in 2015. The increase in activity shows that those at or near retirement are actively reviewing their pension pots, as they look to explore their options, and potentially transferring out of their DB schemes.

The real trade-off of transfer However, there is always a danger that giving complete flexibility to empty the retirement pot in one go brings the risk of spending it all at once and then having to fall back on the state pension. By transferring out of DB scheme employees effectively relieve their employer of their final salary guarantee to them. A final salary scheme will give a more secure pension than a privately purchased one where any contributions would be invested in the stock market and retirement benefits based on the fund’s eventual value. These sorts of schemes are vulnerable to fluctuations in stocks and shares, and for some, this type of risk simply isn’t a suitable option.

The right decision for you Pension freedoms appear to have been making a considerable impact on consumers, and 43 i-invest January 2016

have acted as a catalyst for many to reassess whether remaining in a DB scheme is the best option. However, it is important to recognise that transferring out from a DB scheme is not suitable for everyone, and a decision as complex as this should not be made hastily but with comprehensive financial advice. Modern retirement is changing quickly - we have an ever-increasing life expectancy, better health in later life and a growing appetite to continue working past traditional retirement age. It is vital that people balance the decision to access savings in early retirement, compared with the likelihood that they will live for a long time.

Increased choice is always a good thing, so long as it is harnessed responsibly.

This sets the scene for Advisers, who along with the impartial government guidance service, have challenges to ensure better outcomes for consumers. With relatively low take up of the Pension Wise guidance service* and Advisers working at full capacity, there are concerns that there is an advice gap emerging, leaving too many retirees to their own devices.

One way to help tackle the advice gap is the use of technology, whether this is by means of people being able to engage with their pensions digitally in a way that suits their lifestyles today, or through advisers utilising advanced technological tools that allow them to efficiently research and compare the most suitable plans for their clients. The introduction of more choice over retirement options will always be heralded as a watershed moment for consumers in the UK pension system. And harnessing the most efficient and digitally advanced tools will go a long way to giving customers a better understanding of the pensions landscape, better preparing savers to achieve the retirement they want. Isn’t that what the freedoms were meant for?

By Peter Bradshaw, National Director, Selectapension

Accounts

References *Pension Wise staff redeployed amid low take-up

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ESG Factors Govern Investment Decisions Could using ESG across a firm’s full investment portfolio be the future of investment? We speak to Rebecca Maclean, Responsible Investment Analyst at Standard Life, on how this could change the way ESG is adopted throughout the investment industry.

Environmental, social and governance factors have become increasingly popular with private investors and products described as ‘ethical’ investments which use these criteria have become common in recent years.

However, integrating ESG factors into the global portfolio of capital and equity is uncommon for investment firms. This can be achieved by running a Responsible Investment Team which analyses the themes of positive revenue drivers in companies, as well as examining the extent to which firms manage ESG factors.

“We examine global legislation and trends and use this information with regards to the firms we are investing in, or could potentially invest in, to see how these factors could impact on the business.

“I have been on a recent trip to China to explore changes in legislation over there, for example with regards to air pollution, which has recently become an important issue in the country, as well as food safety.

One firm that does utilise ESG throughout its global portfolio is Standard Life, an institution which offers a wide range of investment products such as ISAs, pensions and bonds and examines all of these in relation to ESG factors which are defined by their investors, with the firm performing annual discussions with their consumers to ensure that their ESG standards match those of their customers.

“Food safety has been very prominent ongoing in the Chinese media, with a number of scandals causing serious issues for companies over the past few years. Industries affected include the dairy industry, meat and even fruit and vegetables, with unsafe food having been distributed and causing serious health problems, particularly for young children.

Communication is key to this approach to using ESG, with the firm also keen to engage with the companies they invest in and develop a dialogue between the Responsible Investment Team, Standard Life’s financial analyst and the company being invested in to ensure that they the firm is able to voice their opinion on the ESG factors. This also means that Standard Life can advise firms on how to comply with their ethical standards.

“As this issue is currently at the front of public’s mind because of the high level of media coverage, food safety scandals in China have the potential to have serious implications for the affected brand, with the negative publicity being almost impossible to get rid of.

The firm has a strong Corporate Governance Team which has links to most of the companies that Standard Life invest in, who are able to identify firms which are at risk from issues around their corporate governance, which ensures that all angles are covered when the firm is examining ESG factors within its portfolio.

The Responsible Investment Team work One key reason for using ESG factors across a portfolio is to ensure that any changes in legislation do not have an adverse effect on investment, as Rebecca Maclean, the firm’s Responsible Investment Analyst explains.

“Because of the seriousness of this issue the Chinese government has increased its efforts to combat this problem by introducing new legislation, for example in November of last year there was a new food safety law which included more stringent regulation on infant formula milk, and greater transparency on health data for food. This update also included details on stricter punishments for those found to be breaking the law, which will also have a serious effect on business. We view this as a step in the right direction, and have been speaking to firms in the country on how they will be adapting to the new regulations and how the regulatory environment is changing.

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“From an investment perspective, I am now going across and speaking to the individual teams within firms in this sector globally across credit and equity, to see how their company is positioned on food safety in China so that I can identify the companies that are actively working to improve their food safety and comply with regulations and which firms have more scope to make changes both within their own organisation and their supply chain.”

This approach ensures that the firm is aware of the market, both from a risk perspective and enabling them to identify new companies which already comply or are moving to comply with the new regulations.

Despite identifying a very small section of the market, Rebecca was keen to emphasise that ESG is utilised throughout the company and was an important aspect of how the firm organises its investments.

“Our policy on ESG comes from the very top level of our institution, with the drive and the strategy to promote ESG is coming from our Chief Information Officer, all the way down to individual analysts, which differentiates us for other asset managers.

“The reason we are so keen on ESG is because of the financial materiality of ESG, as there are a number of identifiable ways in which environmental, social and governmental issues have had a material effect on a company’s share price. This financial impact that ESG factors can have on investments is the principal reason why Standard Life analyses these factors so meticulously across their global portfolios.”

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UK SRI Green Money The UK is Europe’s largest Sustainable and Responsible Investment (SRI) market with at least £1.4trn worth of assets under management according to the 2014 Eurosif SRI study.

These advances in UK SRI mirror growing acceptance in society and politics that issues such as climate change, human rights and executive remuneration are no longer the preserve of a minority group of ‘ethical’ or values-driven investors.

Our SRI sector framework is well-developed and far-reaching with all the expected commercial elements at play: large retail and investment banks, significant institutional asset owner interest, a small but vibrant share of the retail investor market, a large number of fund managers and a wide range of supporting services such as data providers, investment consultants and research houses.

For example, the UK Government was the first to set a binding target on emissions reduction in 2008. Then media coverage of incidents such as the Gulf of Mexico oil spill, consumer boycotts of Starbucks’ and Amazon over tax, and the tragedy at Rana Plaza in Bangladesh where a factory collapse killed over 1000 people crystallised mainstream public opinion behind the principles of SRI and corporate responsibility.

The UK Sustainable Investment and Finance Association (UKSIF) – previously the UK Social Investment Forum - was founded in 1991 as the membership network for these UK financial services firms and now has over 240 members and affiliates of all sizes and types.

These incidents also of course showed investors that poor environmental, social or governance (ESG) practices had huge financial implications so SRI thinking as risk mitigation has undoubtedly become important albeit not the only function of SRI.

There is a long history of ethically motivated investment in the UK. However, SRI investment as we now know it can be traced back to two Quakers who started the Friends Provident Institution on a mutual basis in 1834. In 1984 Friends Provident launched the first ethical UK fund – a retail savings trust - screening out arms, alcohol and gambling.

Pension funds are an important current area of change. UK pension funds were the first in the world to see regulation that required trustees of occupational pension schemes to disclose in their Statement of Investment Principles (SIP) whether they have a responsible investment policy. UKSIF is very proud to have been instrumental in achieving it: the consultation process was started by the UK Pensions Minister at UKSIF’s 1998 Annual Lecture, attracting support from all the major political parties and a range of leading UK pension funds and major City institutions. Similar regulation has since been implemented in countries such as Australia, Sweden, Canada and Germany.

Nowadays, UK professionals don’t just exclude particular industries but practise a wide range of techniques and approaches to SRI. Company voting and engagement and ESG integration (the integration of environmental, social and governance factors into company valuation) are leading examples.

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The next step for UK based trustees concerned about the long-term value of investments to their beneficiaries came exactly ten years later in the form of The UK Stewardship Code. The Code was published by the Financial Reporting Council to enhance the quality of engagement between institutional investors and companies on their governance practices. The code is opt-in and applied on a comply or explain basis. As the Code explains: “Stewardship aims to promote the long term success of companies in such a way that the ultimate providers of capital also prosper.

Effective stewardship benefits companies, investors and the economy as a whole. For investors, stewardship is more than just voting. Activities may include monitoring and engaging with companies on matters such as strategy, performance, risk, capital structure, and corporate governance, including culture and remuneration. Engagement is purposeful dialogue with companies on these matters as well as on issues that are the immediate subject of votes at general meetings.”

The vast majority of UK fund managers have signed the Code. Again, the UK earned itself international attention with equivalent codes being launched in countries such as South Africa, Malaysia and Japan.

A long-running difficulty for SRI in the UK has been with fiduciary duty. Based on a 1985 law case, the view developed in some influential quarters that SRI was not appropriate for pension funds and could be a breach of their fiduciary duty to scheme beneficiaries. Similar attitudes-and professional advice- then crossed over into charity investment.

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In 2013, for example, Comic Relief, one of the largest and most high-profile charities in the UK, was criticised because donations had been invested into tobacco and arms. The Charity had been advised that their fiduciary duty placed a legal requirement on them to invest in the most profitable stocks in spite of their values; no one had seen official guidance in 2011 that trustees of any charity can decide to invest ethically, even if the investment might provide a lower rate of return than an alternative investment. Comic Relief has since announced a new investment policy in May 2014.

But things may be beginning to change. Part of the Government response to the financial crisis was a review of how equity markets functioned. The Kay Review, published in 2012, drew attention to confusion over fiduciary duty and recommended legal clarification. This came in 2014 when the Law Commission said that trustees should take financially material ESG factors into account. It also made clear the law was sufficiently flexible enough so that trustees may take into account non-financial factors in certain circumstances.

These are important findings. The UK Government Department for Work and Pensions is currently consulting on what changes to the Investment Regulations are required following the Law Commission’s report. UKSIF is calling on them to ensure that the clarification around ESG and non-financial factors is included in the regulations to ensure trustees are under an obligation to consider them. This is potentially an extremely significant event.

In the retail space there is a large number of SRI funds available to savers, but the market is not easy. Retail finance is heavily regulated in the UK and professional advice is understandably not cheap. Letting people know that they can express a view on how their money is invested is very difficult despite the efforts of UKSIFs members in this sector. This may take some while to change.

Indeed gains in retail consumer interest may be dependent on institutional owners introducing their beneficiaries to SRI concept through, for instance, pension fund reporting.

In banking the outlook is still clouded. In common with banks from most countries, the UK firms seem unable to end the continuing saga of fines and scandals linked to the crisis and post-crisis years. This is despite the senior management in the sector apparently understanding the need for behavioural change and trying to develop and instil values of the kind UKSIF is willing to support. There is a steady stream of new “challenger” banks such as Aldermore, Shawbrook, Ffrees Family Finance and Metro Bank - which aim to offer better service but customer inertia is high.

NGO activity will continue to push for change.

Currently, there is talk of a legal test case linked to climate change risk and fiduciary duty and the wonderful work of CTI (formally Carbon Tracker) on stranded assets and the carbon bubble is getting excellent coverage. In our view 49 i-invest January 2016

the past six months have seen a step change in the attitude of influential mainstream media to these issues due to their work. We are also home to other significant bodies such as the PRI, CDP and the IIGCC. There are some important developments among asset owners who are variously pushing for fund managers to improve their SRI reporting – particularly on outcomes, they are laying shareholder resolutions at AGMs calling for increased corporate transparency and - one UKSIF has worked hard to support - evolving a set of voting instructions which owners can easily place on their managers. Clearly what clients want clients will get so these are welcomed boosts to the SRI marketplace.

There are also interesting innovations in the social space. One is social impact bonds. The first Social Impact Bond (SIB) was launched in September 2010 by Social Finance, a not for profit organisation, at Peterborough Prison to fund offender rehabilitation services. Since then, a total of 14 SIBs have been launched in the UK and more are being developed. SIBs are typically small issues – £5m for Peterborough – where investors take on the financial risk of a particular social intervention becoming successful or not that is usually sustained by governments.

Governments reward investors for taking on this risk by coupon and capital payments linked to results. Social Finance says there are now 100 initiatives being explored across the world.

Our opinion polls show that the public is interested in SRI issues. Research for UKSIF’s Good Money Week showed that just over half of people want to consider the good their investments will do as well as the financial return. As mentioned above, what is difficult is letting the public know that SRI investments are available and we are currently reliant on the media covering the issues and the top-down effect of institutional activity to help.

Nonetheless UKSIF is optimistic. Our climate arguments are increasingly seen as mainstream; the UK Stewardship Code is an accepted feature of corporate life as is active voting by fund managers. The public are becoming aware that all is not right and that changes are possible.

Great progress has been made in the past 20-30 years and we hope it will continue.

Simon Howard, Chief Executive, UKSIF Charlene Cranny, Programme Manager, UKSIF

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Pension Liabilities Managing Employer Risk in the LGPS

Recently the government outlined plans for area reviews of Further Education colleges and. with new forms of public services emerging it is vital to fully understand pension issues when transforming public services.

Pensions are one of the largest liabilities on an employer’s balance sheet but few understand the difference between ongoing, FRS17 and cessation liabilities. Even fewer understand the implications of crystallizing cessation liabilities.

The main reason of covenant reviews is to prevent pension liabilities falling on other fund employers in the event of employer default and on the taxpayer.

In addition, if you fully understand the employers in your fund there is less risk of employers being unable to meet their pension obligations in the longer term although, ultimately, not every insolvency can be avoided.

Why perform covenant checks?

Quite simply, it is now a regulatory requirement to monitor employer covenant under Pension Regulator requirements relating to all Public Sector Schemes from 1 April 2014.

What you can do, however, is establish where an employer is having difficulty in meeting its pension obligations and then appropriate action can be taken. For admission bodies this may mean negotiating a managed exit from the fund with liabilities met through a legal payment plan and for scheduled bodies this may mean detailed discussions with funding bodies.

In the LGPS between 10% and 15% of pension fund liabilities relate to admission bodies, with a mix of recent outsourcing functions and old historic admission agreements. In our fund, for example, some historic admission agreements were executed in the 1950s.

In depth covenant reviews should also be performed for new employers looking to join the LGPS. No admission body should now join the LGPS without risks being mitigated either via security or a letting body underwriting the admission agreement.

Engagement with employers can bring real benefits to funds in fully understanding an employer’s financial position when setting employer contribution rates at triennial valuations or determining if the LGPS remains as the best pension provision for their organization.

Once key risks have been identified you are then in a position to actively manage and monitor that risk.

At LPFA we have developed sector specific covenant checks which relate to the main groups of participants in our fund. Over the past three years we have worked with Government Departments, Funding agencies and representative groups to understand key risks that relate to specific sectors. The main sectors in our fund include: • Social Housing • Charities • Higher Education Sector • Further Education sector • Academies

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You also need to be aware of any changes to the legal status of an employer that requires the admission agreement to be updated, and all outstanding assets and liabilities of the former body will need to be rolled forward into a new agreement.

It must be recognized that it is not always in the best interest of either the fund or the employer to remain in the fund accruing further liabilities when a managed exit may be the best option for all parties. Certainly one of the frustrations in the charity sector is that a consistent approach is not adopted across the LGPS, and this certainly in their view seems to apply to managed exits.

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Presenting and enforcing a cessation debt, where the employer does not have the monies to pay the liability is unlikely to be in the best interests of the fund. It is far better for an employer to exit the fund and the liabilities be managed over time than force an employer to become technically insolvent. Without security in place it then becomes extremely unlikely that a fund will recover the monies due.

Sector involvement in the LGPS It is becoming clearer that sectors within the LGPS are becoming increasingly active and are keen to be involved in the scheme; they have significant assets invested on their behalf and would like to have a degree of influence. A number have made their own representation to government departments and employers are seeking seats on new look pension boards.

It is important in my opinion that the views of various sectors are taken into account when setting LGPS Regulations and policy. There are certainly a number of key sector concerns that require detailed discussion and debate over the coming months and the PWC deficit reduction paper produced for the Scheme Advisory Board covers some of these in detail.

Within our fund we have set up regular forums with further and higher education sector employers and we have engaged regularly with interested parties in the other sectors our employers participate in.We continue to work to develop understanding of key pension issues and one key success has been the sharing of financial information in the Higher Education Sector.

Although government departments now have a better understanding of pension liabilities there is still confusion, in particular between FRS17 and cessation liabilities, but we continue to develop understanding and best practice on pension issues across government departments.

Scheduled bodies can pose risks to the LGPS and the forthcoming area reviews for Further Education colleges will require a uniformed approach to be adopted across LGPS funds and Government to ensure any pension deficits are dealt with effectively.

It is only through employers or funding bodies providing early indication of any college mergers or dissolutions that pension issues can be resolved without causing delays to policy decisions.

Why take additional security There are a number of reasons why a LGPS fund should look to take security over assets these include: • giving a Pension fund priority over other creditors; • giving a Pension fund priority over other creditors; • implementing Security can provide long term stability to an employer’s contributions; and, • preventing the risk of pension liabilities falling on other fund employers.

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Forms of Security • Security can take a number of forms including: • First charge on assets.

• An employer demonstrating Security of income streams.

• Monies held in an ESCROW account.

• Provision of Parent Company Guarantees.

Participating with fund employers • Working with fund employers to understand pension liabilities is not easy but we have made significant progress in the following key areas: • Helping employers to fully understand the key differences between ongoing, FRS17 and cessation liabilities.

• Providing all fund employers with a cessation valuation at each triennial valuation makes employers aware of the ultimate liability due to the fund.

• For employers who have few active employees or pose a risk to the fund we provide an annual cessation figure.

• We use Pensions Regulator covenant guidance in setting employer contribution rates and explain to employers the key balance between contributions being paid to the Pensions Fund and the need for an employer covenant to grow and the organization to thrive in the longer term.

Internal Monitoring.

Pension committees and local pension boards should have a keen interest in monitoring risk and provision of reports on employer risk should be a regular agenda item on any Pensions Committee and Local Pension Board agenda.

The Funding Strategy statement, which forms a key part of the triennial valuation, should outline to employers in detail the key approaches being adopted including differential discount rates being applied to different LGPS employers.

Going Forward We believe that the approach we have taken has helped mitigate risk in our fund and can be of benefit to other LGPS funds. We have implemented over £300 million of guarantees and first charges since the 2013 valuation and ongoing risk management together with Asset and Liability management forms a key part of our risk philosophy going forward.

“It is only through employers or funding bodies providing early indication of any college mergers or dissolutions that pension issues can be resolved without causing delays to policy decisions.”

By Tony Williams, Head of Employer Services for the London Pensions Fund Authority.

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Asset Allocation & Investment 2016 Series Following extensive surveys, reviews and sector engagement, AI Global Media is proud to announce the Asset Allocation & Investment 2016 Series.

A series of dedicated publications, with a purposely limited number of commercial contributors, designed to focus on specific themes as highlighted by our extensive sector wide surveys.

Below is a Forward Features List of the first eBooks in the series, if you would like to provide input, commercial profile or a product advertisement into any of the features listed or would like to suggest a new feature, get in touch on the contact information at the bottom of the page.

Announced Forward Features; “The New Dynamics of Impact Investing” – Increasing popularity from investors, driving innovation and sophisticated product development look to push Impact Investing even further into the mainstream. What does the landscape look like for Impact Investing in 2016 – Perspectives from Asset Owners, Managers, Academia, Endowments, Trusts, Consultants and others to provide a comprehensive spotlight on this Investment Strategy.

“ESG-Driven Investing – Good for Society, Good for Business” – Buoyed by the exposure and firmer global direction that emerged from COP21, Responsible Investing is at the centre of a great deal of conversations as we come into 2016. However, for the sizable market shift demanded by the COP21 recommendations, financial products need to suit both ESG and financial objectives. With contributions from a diverse range of those that design, provide, research or invest in ESG-driven products, this will be a showcase for the brightest, boldest and most innovative.

“Uncorrelated Returns – Investing in Life Settlements as an Asset Class” – Investors are increasingly interested in methods of diversification and with the ever growing selection of Alternative Investment opportunities and sophisticated financial products, choice is growing. Life Settlement Investing provides several attractive qualities to investors; Uncorrelated Returns, Encouraging Yield, Highly Regulated and Tightly Controlled Industry and the Growth Potential of the Elderly Population – A factor crippling many other sectors. This will be a short analysis of what Life Settlement Investing might offer a savvy modern investor.

“Bitcoin Investing – Only for the Brave or an Unmissable Opportunity?” – Irrespective of your depth of technical knowledge, you can’t fail to have heard of Bitcoin; both as a groundbreaking technology capable of vast disruption in the payment market and as an investment opportunity. Reporting of vast fortunes generated by the tech savvy and brave investor are spreading, this feature will look to address the balance and provide a look into what Bitcoin might offer a savvy modern investor.

Still to Come; Smart Beta – The Perfect Balance of Active, Passive & Systematic or Rewarding Failure/ Restricting Growth?

Investing in ETFs (Spotlight on Biotech & Life Sciences)

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Investing in European Credit Auto Enrolment in Small Businesses – Time is Running Out (Case Study on the Care Sector – Unique Challenges but the Same Responsibilities) Virtual Data Rooms – Collaboration, Security, Efficiency and the M&A Boom (Case Study on Health & Life Sciences) The New Dynamics of Emerging & Frontier Markets – Where to Find Value To enquire about participating in any of the above features, or to suggest a new feature please get in touch on the address below.

Oliver Hambleton Partner Relations Oliver.hambleton@I-Investintl.com

WHERE THINKING DIFFERENTLY IS THE NORM

UNCONSTRAINED INVESTMENT EXPERTISE, EVERY DAY TEL. 020 7150 4005 OR VISIT WWW.QUILTERCHEVIOT.COM

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