Presentation: Building a Responsible Hedge FundTBLI Zurich / Larry Abele8 November 2012I will start with a brief disclosure of my biases. From 1986 to 1989 I studied Public economics atVirginia Tech University under Dr Nicolaus Tideman and focused on land value taxation – moving taxoff capital and labour and on to natural resource use. Then from 1990-1994 I spent four yearstravelling by foot as part of the Global Walk for a Liveable World. We walked through more thanthirty countries promoting sustainable living. After the walk, I returned to university and received anMPhil from the Cambridge University Faculty of Economics and began work in institutional assetmanagement focusing on global tactical asset allocation and equity long/short. In 2004 I foundedAuriel Capital along with two others and in 2009 we developed an interest in ESG and hired AdamSeitchik from Trillium Asset Management to help us integrate ESG into our investment process. InMay of this year we entered into a joint venture with Dr Matthew Kiernan, founder of InnovestStrategic Advisors, to integrate his five factor sustainability model into our approach.In preparing for this talk I borrowed liberally from the Kay Report, Jack Gray’s Misadventures of anIrresponsible Investor, Towers Watson ‘We Need a Bigger Boat’, the UNPRI Hedge Fund WorkingPaper and the UK Stewardship Code.How have we gone about making our HF responsible?We have always maintained as much transparency into our positions and process as our clients needto fulfil their own internal reporting and risk management requirements as well as to ensure theyare in a position to monitor the agreed guidelines for the account. In 2009 in response to the shortcomings of standard hedge fund prospectuses we did a full re-write or our offering memorandumthat is much more investor friendly. We have chosen directors who will truly look at what is in theclients’ best interest. Fee alignment was another area that we improved by adding a three yearperformance fee window. Currently in response to the low cash yield environment we are looking ata hurdle rate to ensure that our fee remains below 30% of excess return.We have started to take our proxy voting seriously and look for opportunities to collectively engageour portfolio companies through initiatives like the UN PRI Clearing House. We encourage ourclients to be active owners and we support their efforts. We joined the Hedge Fund StandardsBoard and we participate in Open Protocol.Much of our work is accomplished by creating a client centric culture at our firm where responsiblebehaviour is the norm. I recall the story of when Warren Buffet took over at Salomon Brothers andgave his famous speech about how he can forgive for losing money but if anyone loses the firm onetiny bit of integrity they are sacked straight away.How do we integrate E S & G into our investment process?First, what is our investment process? Our firm offers active management of European largecapitalisation listed equities. Active management is about creating ‘excess returns or alpha’ by overand under weighting assets relative to a given benchmark. The process by which we choose theseover and under weights, we refer to as our strategy. The success of our strategy will depend on ourskill at predicting which stocks will do better or worse than the others. The universe of stocks weresearch is the 450 largest capitalisation and most actively traded stocks in Europe. Totalcapitalisation is 6.9 trillion Euros.
We offer our strategy with or without a benchmark of the client’s choice. In other words, we offerlong only accounts (where the weights sum to one) or market neutral accounts (where the weightssum to zero). The MN version is for those who already own lots of European equities elsewhere, forinstance in a passive account, or for those who don’t want market exposure for strategic reasons.Our first step was to buy lots of ESG data from vendors such as Trucost, MSCI, and Vigeo so that inaddition to knowing a long list of financial attributes for our companies we now also have a very longlist of ESG attributes in our research environment. So what do we do with all of this information?We started as we would any research project - with hypotheses and some ‘know your data’ analysis.There are many peculiarities of the ESG data we’ve examined (I could spend a whole presentation onjust this) but the most noteworthy is that ESG scores and capitalisation are positively correlated –larger cap stocks score better generally. Vendors acknowledge this ‘feature’ as arising from thebetter disclosure but it is important to note during portfolio construction for instance.As for developing hypotheses as to how best to use the data to better manage our portfolios, wefirst made the conceptual distinction between E and S versus G. E&S are about externalitieswhereas G is about the principal - agent problem. G we had a handle on - we had already beenthinking about governance thru what we referred to as our shareholder value model -- a series ofquestions to ascertain whether senior management through their investing and financing activity aretrying to create shareholder value or pursing sheer size or some other such sub-optimal goal.Governance was an area we could easily build upon given our new datasets from specialistproviders.Researching social and environmental externalities was new for us. Sometimes trade-offs were easy– two companies with the same expected return in the same line of business but one has muchmore pollution than the other. This is easy as the risk of having to pay for one’s pollutions is non-zero so the green firm wins. However, most cases require a risk/return trade-off approach.We have made the decision to have no ‘normative trades’ in our strategy. Any exclusions, negativescreening, or positioning based on avoiding externalities (outside of risk/return framework) areimbedded in our benchmark discussion with clients. Capitalisation weighted benchmarks are out offavour but make an excellent starting point for three key reasons: they clear markets, they are selfrebalancing and monkeys throwing darts will arrive at capitalisation weights. Also these benchmarksare very inexpensive to replicate and have been referred to as ‘bulk beta’. Developing ‘smart beta’by taking some long term tilts in the design of benchmark is gaining popularity. For instance lowvolatility benchmarks, fundamentally driven indexing, or tilts toward equal weights have all becomepopular. Indices based on environmental, social, or governance ratings are also gaining ground.Imbedding these long term tilts into the benchmark design works well for ESG as the data tends tobe very long horizon and generally more suited for strategic rather than tactical positioning.When we speak of responding to ESG as risk and opportunities in our strategy we are talking aboutactive management as opportunity means taking a ‘view’ (against consensus) and risk is the otherside of the coin to return – a unit of reduced risk is worth about a unit of return as we assume ourInformation Ratio is roughly one (meaning for each 1% active risk, we think we can add 1% return).We are looking at ESG as a performance enhancement dataset.In thinking about E & S as risks we can certainly think of industry sectors where pollution is a hotpolitical issue and then compare which companies are doing well and poorly managing the issue.We can look at who has key operations in regions prone to disruption due to social
mismanagement. We can construct portfolios that maintain a net underweight to these types of riskexposures. Our view is that these non-financial risk factors give us a more complete picture.Recently we have begun to look at these non-financial data sets in new ways. For instance our JVpartner’s model looks not only at environmental sustainability but human and organisational capitalas well as the company’s responsiveness and ability to innovate. These next generationsustainability factors have recently been incorporated alongside our other long term inputs likevaluation and Graham and Dodd style security analysis.Long term convergence bets are no panacea however. It is just as difficult to know who will dobetter in a carbon constrained world ‘BMW or Mercedes’ as it is to know how the dynamics of acarbon constrained world will play out. When will we as a world society start to hold managementof our global companies accountable for damages being done? The horizon over which globalmegatrends begin to be priced in has important implications as a portfolio manager approachingE&S as active dimensions to manage on behalf of our clients.There are many horizons to consider as an active investment manager. The following table gives alist of research areas we’ve explored and the time frames we considered with each:Note that we’ve had the most success in finding predictive market drivers at the top and bottom ofthis chart. Often our views developed in different areas conflict (one buying and one selling thesame security). We don’t mind this and do NOT feel that having short horizon trades in any waymakes a mockery of our long term trades, even if they sometimes offset each other. Once researchinto a theme (at any horizon) has made us confident that we can add value by incorporating the newinformation, we assign a conviction by way of a risk allocation. All themes are then netted togetherinto the final portfolio much like a multi-manager approach but with a centralised trading desk.Remember that even great managers are only right about 60% of the time and that across theindustry as a whole alpha is a zero sum game. It is difficult to out-perform at any horizon but ourview is that we maximise our chance by looking across the whole range of horizons. Our goal is todiversify by trade horizon, theme, and security. We have a saying at Auriel that ‘Diversification is theonly free lunch in finance’. We also have three rules for investing – diversify, diversify, anddiversify!
Shorting, short horizon signals and short-termismIt is important for a healthy dialog on integrating ESG into a hedge fund to distinguish a few terms:shorting, short horizon signals and short-termism.Shorting in our context means borrowing shares for the purpose of selling them in order to createnegative economic exposure to a share price movement. Research supports short selling as anintegral part of well functioning markets. However borrowing for the purpose of voting shares isviewed as irresponsible by the PRI as the vote would be de-linked from the economics.Short horizon signals are buy/sell indicators used in the investment management industry that havevery little autocorrelation from one time period to the next – i.e. they are fast. One day momentumor mean reversion would be examples. From speaking point twenty six of the Kay Report, “Shorttermism in decision making in asset management does not, of itself, imply short term decisionmaking by corporate managers. ... The essential purpose of equity markets is to allow savers andcompanies to invest on different time scales.”Short-termism refers to an excessive focus on short-term results at the expense of long-terminterests. Research by scholars John Graham, Campbell Harvey and Shivaram Rajgopal has shownthat corporate managers are making real decisions - such as decreasing spending on research anddevelopment, maintenance and hiring of critical employees - in order to hit quarterly earningstargets they have provided as part of their own guidance to investors. This we can all agree issomething we want to stamp out from our capital markets. First we must acknowledge that we,people/humans, are very bad a slow gradual changes. How many of us exercise regularly and eat aproper diet? The Kay Report cites the famous studies by psychologist Walter Mischel on short-termism with children and marshmallows. Only our frontal cortex gives us any chance of moving toa long-term approach.So how do we humans do in business? I would argue that the owner run business is in much bettershape. I’ve not looked at academic studies but personally I seek out proprietor run restaurants andcertainly since leaving Deutsche Bank and founding a firm, I’ve seen a huge shift in my own mentalitytowards the long-term. This is fine for choosing restaurants or even investment managers, butunfortunately the bulk of our capital is publically listed and thus subject to principal-agentproblems. In the modern corporation the principal – agent problem is both human and structural.For example the City is obsessed with bonuses and yet motivational science shows bonuses don’twork. I’m very sympathetic with the Kay Report in this respect. Finding better structures for themanagement of our vast amount of publically listed capital is of key importance. Lastly thepolitician is perhaps the most short-termism of all the actors and yet also key in participating in thechanges necessary for a sustainable world. I join John Gray in calling for more political engagementby the investment community.Now let’s looks at the industry we’re speaking of - Investment Management – and how each ofshorting, short horizon signals, and short-termism exerts influence. Shorting is a matter of leverageand ensuring that one is using responsible levels of leverage and not leaning on a limited liabilitystructure as risk management. Following clear risk limits that are communicated to clients andmonitored in a credible way is crucial.Short horizon signals is a key area of disagreement in the literature reviewed. If investmentmanagers’ over focus on short horizon trade ideas, does this cause short-termism on behalf ofcorporate management or does it create opportunities for patient capital? We believe it creates
opportunities. If too many investors are focused on short term ideas this will drive down theopportunities. If too few are focused on longer term trades, this will create opportunities. Alpha isvery competitive so I suspect that over time managers will gravitate to the opportunities.Finally a point I have wanted to make all along – there is NO WAY to be short termist as a portfoliomanager. Even in very fast tick data based strategies, the manager is not trading futureperformance for current performance – she simply can’t. All of the portfolio managers I’ve workedwith are maximising the long term compound growth rate of their fund – this includes day tradersand Buffet types. We have played this thought experiment at my office – how can we make thisyear-end return number higher at the expense of future months’ performance? No one has comeup with an idea other than the pitiful ‘gaming risk’ – take loads of risk and if you are correct, youhave big returns and look brilliant. If you are wrong, you go out of business.I will end with a thought on why our large asset owners are focused on long term investing (inaddition to the universal owner arguments). All active management strategies, in every asset class,have a capacity. This is a maximum of amount of active management (risk times AUM) that can bedeployed before market impact overcomes the active management edge. This capacity is a fixedamount of money so as asset owners grow in size, the amount of active management as apercentage of their plan goes down. For very large pools of capital, the opportunity for activemanagement in the sense of security selection may only be 1-2% of total assets. Given that longerhorizon signals have more active management capacity, it may simply be a matter of practicality.