A bee in my bonnet about stock lending

Stock lending is a practice which many, but not all, asset managers have participated in for decades.  The income received sweats equity assets a little harder and provides some extra liquidity to markets.  The stock lent is usually used to arbitrage tax differentials between different investors or to enable institutions wishing to go ‘short’ to deliver stock when they sell. However, I am increasingly wondering whether it really is consistent with the spirit of acting as a responsible investor, as pension funds are mandated to do.  One of the key tenets of the Stewardship Code is to use your vote at General Meetings but if you have ‘lent’ your stock you have to recall it in time to do that.  In theory, this is always possible but it undoubtedly adds brittleness to the system: the owner may be up against a tight deadline and the chain of stocklending may involve several parties.    My other concern is that the lender of stock cannot prevent his stock being used for aggressive shorting, which I believe is directly contrary to the notion of being a responsible investor.  The Stewardship Code simply states that investors should state their policy on stock lending, so the practice is not in direct contravention, but I cannot bring myself to say that it is consistent with the spirit behind the Code. Ultimately, the judgement investors have to make is whether the return from lending stock makes it worthwhile and I am aware that passive investors in particular often rely on the practice to cover the frictional costs of running an index portfolio.  Buzz, buzz, buzz… If you have a view on this subject please do contact me. ​

The future of research

The advent of MIFID2 in January has led to some significant changes in how asset managers obtain their research.  I attended the 4th Global Independent Research Conference yesterday and it is clear that there is still a lot more to come.  Two months after MIFID2 kicked in, many large buyers of research have either cut their research budgets, or simply issued ‘cease and desist’ notices on their research providers at the behest of their compliance departments while they make sure their houses are in order.  Large investment banks’ research departments have slashed their proposed fees, perhaps going for volume, while smaller independent firms seem to have borne the brunt of the cuts. The conference keynote speaker from the FCA made it quite clear that the new rules do not in any way force buyers to act as they have.  There is an onus on them to demonstrate value obtained for the end-client, always a difficult subject with research, but the FCA speaker was explicit that did not mean that research could not be received while they sort out internal processes.  Nor do the rules preclude offering trial periods at nil or reduced cost, or providing sample research while looking to clinch a sale.    What happens next?  The FCA painted a picture of sunny uplands where independent research can compete on a level playing field with the large banks.  In contrast the general consensus among most providers was one of, in the Duke of Wellington’s words, hard pounding.  The optimists remained hopeful that pricing would rise and that firms who chose to research internally would actually end up with larger research budgets.  The pessimists focused on the availability of free research, and the passing of control among the buy side to the Finance Director and compliance departments. In the longer term, the availability of good quality research is important.  Without it, markets become less efficient and companies may choose to turn to other sources to find finance.  In the short term, perhaps the best thing the FCA could do is to send a message to buy-side firms to make it clearer what is and what is not permitted.   And portfolio managers represent to their compliance teams the need not to be more draconian than necessary. ​

What does Carillion mean for investors in infrastructure?

The Carillion debacle has put the spotlight firmly on the outsourcing model whereby a company wins a contract and then uses contractors to provide some or all of the services.  There are plenty of people who have serious questions to answer, including the directors of the company, the auditors, government procurement and The Pensions Regulator.  But what does this mean for investors, and particularly pension funds, who have put substantial money into the closed end funds which have often financed the PFI deals which were Carillion’s bread and butter business?  Some quoted infrastructure funds, such as HICL Infrastructure, have already taken a hit to their NAV as they put in place more expensive alternatives to Carillion.   Private funds are certainly going to have to do the same, which will in due course affect returns and valuations, though the nature of their valuation process means this may take months or even years to come through. The longer-term threat is a move away from the PFI model, with the public sector - and this is chiefly about infrastructure investment - choosing to do more in-house.  It is no secret that PFI is expensive - tales of £500 to change a lightbulb abound – and pension funds have been one of the beneficiaries.  In my view public opinion is less and less willing to accept this price-gouging aspect.  A renationalisation under a left-leaning government is unlikely, simply because unwinding the legal contracts would be horrendously complicated.  However, like BBC (male) salaries, the pressure voluntarily to change the terms of the contracts to make them less expensive could become unbearable.    Ultimately, I see Carillion as a governance problem: outsourcing can work well but the entity at the centre needs to be incentivised to ensure the business model is sustainable.  That includes prioritising cashflow so that senior executives and shareholders only get their hands on it when suppliers have been paid, the pension fund has been funded and the contract has been delivered on terms which are fair to the customer in the long term.  Capita’s Directors seem to have seen the light at the eleventh hour, with yesterday’s announcement moving away from the Carillion model. From an investment perspective, infrastructure still makes a good match for a pension fund’s long-term liabilities.  However, investors need to cast a sceptical eye over how sustainable the business model is. To find out more about Linchpin’s advice and support in relation to governance click here.​

DCLG response to Law Commission paper on social investment

The DCLG slipped out an interim response to the Law Commission paper (274) on Pension Funds and Social Investment a couple of days before the Christmas break.  The recommendation is to accept the original paper’s recommendations to encourage pension schemes to place more emphasis on ESG considerations when investing, although DCLG will consult on some before enacting them.  While the LGPS is statutory rather than trust-based, legal opinion has previously made it clear that these changes will also apply to them. The most important new requirement is for pension schemes to ‘state their policies’ in relation to how they evaluate investment risks, including ESG considerations, in the long term (our italics).  While most funds will already be considering the financial risk to portfolios from climate change, there will now be a legal requirement to do so, or at least to state publicly if choosing not to.  The implications are wider than just climate change: it will become less easy for a company to pay its senior management disproportionately, for example. The second proposal is that pension schemes should say how they will consider and respond to members’ ethical or other concerns.  Again, a fund may choose to ignore them but will have to state publicly that it is doing so.  We expect most will find it easier to find a way to respond. If an administering authority wishes to make an investment or divest for ‘non-financial’ reasons, it will still have to pass the two tests set by the Law Commission: no significant financial detriment and that members share the concerns.  There is some interesting language on the latter point in the Law Commission paper:  if an authority does conduct some form of broader consultation - as opposed to, for example, simply asking the Local Pension Board - the bar to pass the test is not necessarily complete agreement. However, a court would consider a significant minority disagreeing sufficient to fail it. The administering authority would then have to make its investment decision on financial grounds only.  Apathy and lack of response need not be taken as disagreement. In practice, most LGPS funds seem to prefer engagement - through LAPFF or more directly - to divestment. However, at the margin, the legislation will perhaps make it clearer what is required in order to divest from, for example, fossil fuels and will make it harder for funds to ignore well-organised pressure groups.    ​

Is divestment really the esg answer?

Responsible investing is taking up more and more of my time at the moment.  Don’t get me wrong:  long-term investing institutions wish, and should wish, to invest in sustainable businesses.  That makes it important to look at environmental, social and governance (“ESG”) considerations.    The difficult bit is what to do with companies which don’t tick all the boxes.  One option is simply to divest and exclude, which is what fossil fuel activists, as an example, promote.  (A small memo item here: the vast Norwegian sovereign wealth fund has chosen to divest from oil primarily for reasons of diversification, not for ESG reasons.)   Let us leave aside for the moment the important question of the fiduciary duty to act in the financial interest of the pension fund.  The problem with divestment is that i) any ability to influence the company’s behaviour is limited, ii) the company is owned by shareholders who may not care at all about sustainability  - look at Thames Water for an example.  Activists will respond by saying that leopards don’t change their spots and tobacco companies, for example, are never going to stop selling tobacco, so that doesn’t matter.  In my view, that is too harsh a view: even within ‘sin’ sectors, there is a huge variance in behaviours and companies change over time.  It is not sufficient to simply depict companies as good or bad. There is a growing number of ‘sustainable’ funds which exclude stocks which do not pass the relevant ESG criteria.  Their claim is they can deliver equivalent returns and I do not dispute that.  I prefer this approach to straight divestment, because it allows for companies to move back into the investment universe if they clean up their act.  However, this approach does not avert the problem that, without being a shareholder, engagement with the company can only be limited. The alternative approach focuses on engagement in some form.  There are pressure groups (for example LAPFF within the Local Government Pension Scheme) who are undoubtedly having some positive effects by targeting quoted companies.  The real challenge is to make the power of institutions’ passive holdings work when an institution cannot even threaten to sell its holdings.   Here the growth of ‘tilted’ passive strategies may help, because they send a signal to the target companies without necessarily divesting completely.  However, it should be noted that the cost of running a tilted strategy is several times higher than a traditional passive mandate.  It is not a cost-free strategy and nor will it keep the activists off an institution’s back. To learn more about Linchpin’s governance services please click here. 

William Bourne comments on the latest LGPS cashflow data in Room 151

To read the article please visit Room 151.

Advisers or advisors?

The requirements of MIFID2 are now centre screen for firms on all sides of the asset management industry.  The newspaper headlines focus on the requirement to unbundle and pay separately for research, but for LGPS Funds the categorisation by default as retail clients has caused the most angst.  Most, if not all, will wish to ‘opt up’ to professional status, so that they can continue to invest in lower fee vehicles.   After many months and heavyweight representations to the FCA, there is now a template which they can complete to ask fund managers to opt them up, which contains both quantitative and qualitative criteria.  The latter are intended to ensure that there is sufficient expertise present that the client can understand the advice and information given by the fund manager. As always with something done in a hurry against a deadline, in this case 3rd January 2018, there are some anomalies and unintended consequences.  The first question is who needs to opt LGPS funds up.  Managers do, of course, but what about consultants and advisers?  In theory any firm or individual providing regulated advice (FCA definition) on specified investments should do so.  As pool subfunds will be included in this definition, and individual LGPS Funds will continue after pooling to be responsible for allocating between them, there is a clear argument to say that any entity assisting them with advice in this area needs to be FCA regulated and to opt their clients up.  However, asset allocation and general advice are not regulated activities, and the funds’ investment activities are, according to the guidance on pooling provided by the Government, explicitly restricted to asset allocation.  Which suggests that there is no need.Despite the arguments both ways, the direction of travel is fairly clear and I would expect anyone providing specific advice on individual subfunds - as opposed to commenting on, for example, an investment consultant or pool’s choice of them - to end up requiring to be FCA regulated, and having to opt his/her client up.  Personally, I am going to rely on the wording in my contract which defines my duties as providing ‘general’ advice. To confuse matters further, what the industry knows as the consultant is the adviser from the template’s perspective and vice versa.  This is because it refers to the entity advising the firm on its Investment Strategy Statement (ie. ‘advising’ as per the LGPS regulations and not in the FCA meaning of the word).  Where both investment consultant and independent adviser are present, that will be the former, so the latter has to be put down as consultant. Then there are the qualitative criteria, such as longevity of tenure.  An Officer at one of my clients has 38 years in post and we are joking that MIFID2’s requirements mean he will not be allowed to retire because they need to keep the average years of experience up.  There’s also the form’s usage of the American ‘advisor’, whereas my LGPS contracts use the English form ‘adviser’.   I could go on and on, but I have to go and feed my dog her morning meal.  I must be careful not to get the MIFID2 ‘opt up’ process muddled up with what I normally give her!

Environment, social and governance (esg) is an opportunity for the new lgps pools

Almost every investment and governance conversation I’ve had in the past six months has, to a greater or lesser extent, mentioned ESG.  And almost every investment house, bar the hard-core profit-maximisers, have included ESG in their marketing in some form or another.   One driver is the pressure groups arguing for divestment.  Increasingly, they are moving away from demonstration tactics towards using financial arguments, such as the potential downside from being invested in stranded assets and the unsustainability of poor working practices.  They may still only be presenting one side of the argument but their voice is now heard at the table.  For example, a recent LGPS Strategy Day I attended focused on ESG and invited the local climate activists to attend to state their case. A second is the growth of funds focusing on sustainability.  Their argument is that it is better to focus on what works in the long term rather than explicitly excluding ‘sin’ stocks.  By virtue of their process, they argue, the latter will be excluded anyway. A third is the public scrutiny around certain ESG issues such as executive remuneration and, increasingly, the realisation that shareholders can have significant influence through engagement.   The LGPS can take some pride that, via LAPFF, it has been at the forefront of engagement with some notable successes.  The debate between these three different approaches - whether to engage, divest or simply look elsewhere - is at the centre of today’s ESG policies.  There is, of course, unlikely to be a perfect answer and different companies will need different approaches.  Persuading a tobacco company to disengage from tobacco is always going to be a hard sell and yet mechanical divestment rules can easily lead to artificial (and potentially costly) investment decisions. Given the LGPS’s longstanding focus on ESG, this is something which all the pools currently being set up will have to embrace.  Some are already setting up sustainable or ethical funds.  If done well, it could be a major selling point to those participating Funds who are perhaps less convinced by the financial arguments for pooling.     At Linchpin we are ready to help - find out more here.