Institutional investors, primarily pension funds, dominate today’s global financial markets. Increasingly these investors are turning their attention to the world’s emerging markets where rapidly expanding growth rates generate higher returns on investment than home markets can provide. Anglo-American pensioners and future pensioners are becoming dependant on the developing world’s growth in order to secure the developed world’s retirement living standards.
But risk and return go hand in hand, and while the potential returns from these investments are high, the risks involved in such markets are equally high. The result is institutional investors increasingly vulnerable to firm-specific and country-level risks systemic to global capital market exposure.
Given the variety of risks pension funds and other institutional investors face in far off markets it is little wonder they are demanding systematic and standardised measurements of both financial and non-financial behaviour. Witness the recent pronouncements on this topic by the Association of British Insurers. We call this phenomenon the global institutional investment value chain (see below).
The value chain links the demands of institutional investors with increased unified global standards of corporate, social and environmental behaviour and the heightened transparency necessary to benchmark the outcomes of such behaviour. What is interesting is that pension fund investors such as the giant California fund CalPERS, apply the global investment value chain not only to individual firms in emerging markets, but to whole countries' corporate practices.
In February of 2002, CalPERS stunned the financial world with their decision to remove entire countries from their emerging markets portfolio on the basis of both country-specific factors including political stability, transparency and productive labour practices combined with capital market factors of liquidity and volatility, regulation, openness, settlement proficiency, and transaction costs. CalPERS, then the largest pension fund in the world with assets of $163bn (E132bn) , stated that such a move lowered risk in emerging markets and therefore fulfilled its fiduciary obligations to both pension plan beneficiaries and plan sponsors. The world’s business media was stunned by such a bold and sweeping decision on the part of a major global investor, one that effectively removed 25% of the available emerging market investment from CalPERS’ portfolio.
Traditional financial analysts argued that such blanket screening, particularly based on non-financial criteria, compromised CalPERS’ potential portfolio returns because it neither gains from investing in the full market (beta), nor does it allow for the possibility of finding market out-performance (alpha) in countries systematically removed from the portfolio. Based on this analysis such an investment decision automatically under-performs more complete emerging market indices and benchmarks. However, to date CalPERS’ emerging market portfolio has outperformed its benchmark.
Interestingly, CalPERS’ emerging markets decision also drew criticism from development NGOs on the basis that country-wide exclusionary screens act as barriers to the overall development needed by these countries in order to raise living standards more generally. Not only did CalPERS’ officials have to brave the condemnation of both traditional financial analysts and NGOs; they also faced the Philippines Government’s instant rebuttal of their data, and three months later CalPERS reinstated the Philippines in their investment portfolio. Given the levels of internal debate within CalPERS on the advisability of using countrywide screens, capped off with a narrow seven to six board vote in its favour, it was not an auspicious start for this bold initiative.
After a lengthy consultation process CalPERS chose to maintain investment in 13 of the 27 countries within the its emerging market investment universe. These countries included Argentina, Brazil, Chile, Czech Republic, Hungary, Israel, Mexico, Peru, Poland, South Africa, South Korea, Taiwan, and Turkey, with the Philippines reinstated in May of 2002. Excluded from investment were China, Columbia, Egypt, India, Indonesia, Jordan, Malaysia, Morocco, Pakistan, Russia, Sri Lanka, and Thailand.
The impact of exclusion from CalPERS’ portfolio went well beyond CalPERS’ own direct investment. The reputational damage caused a domino effect with other foreign investors also divesting from these countries. Even the three-month exclusion of the Philippines resulted in millions of dollars of external capital flight for that country. Our recent study of CalPERS’ emerging markets screening suggests that along the institutional investor value chain nation states remain key actors in global standards setting (see Hebb and Wojcik study: ‘Global Standards and Emerging Markets: the institutional investment value chain and CalPERS’ investment strategy’*). Absent global government, most global corporate standards continue to be voluntary with material disclosure remaining patchwork at best.
In contrast, national regulatory regimes provide legitimate and legally binding standards on all corporate entities operating within their defined national boundaries.
Our study finds evidence to back investor intuition that applying both financial and non-financial standards to entire countries within emerging markets portfolios acts as a catalyst to raise standards beyond those currently consistent with these countries’ regulatory frameworks. We are able to show that countries’ convergence to uniform global standards is accelerated by external investors’ threat of capital flight. While these standards may well be minimum requirements, raising them directly improves both global standards of behaviour and by extension global equity and social justice outcomes. We find that countries and their regulatory regimes are central to external capital investment decisions and that by using their investment leverage, pension funds such as CalPERS can have a profound impact on the global standard setting process.
Tessa Hebb is a doctoral candidate in Economic Geography at the University of Oxford where she is researching the long-term impacts of pension fund corporate engagement under the supervision of Gordon Clark.
*This study can be found at Global Institutional Investment Value Chain