…as PGGM tweaks alpha/beta separation

Johan van der EndeAs the credit crisis continues to wreak havoc with financial institutions balance sheets and new credit and market risks appear to lurk around every corner, the search for optimal asset management strategies has reached new highs.

For several funds, the pressures of market downturns have proven too much to bear, prompting significant changes in asset allocation. Others, however, have opted to take a longer-term view, optimising the fundamentals of their investment strategies to better reflect future asset management opportunities. Netherlands-based PGGM Investments belongs to the latter category.

With €86.3 billion ($117 billion) under management, PGGM Investments is the exclusive asset manager for pension fund Pensioenfonds Zorg en Welzijn (PFZW), the pension fund for the Dutch care and welfare sector.

“We base our asset allocation mix on long-term economic projections,” says Johan van der Ende, chief investment officer at PGGM Investments in Zeist, the Netherlands. “Of course we revisit these plans on a yearly basis, but we will not let short-term market developments cloud our long-term prognosis.”  PGGMs asset allocation process is centred around its objective to realise stable returns in different economic regimes and provide indexed pension payments to PFZWs two million scheme members

“The composition of the optimum investment mix is determined using asset/liability management (ALM) techniques, combined with the input from our strategy and research team which looks at long-term growth prospects for various markets,” explains van der Ende.

The fund’s 2008 plan reflects the intention to increase the stability of returns, and reduce exposure to specific equity market risks which have come to the fore during the recent market turmoil. For example, the weighting of equities has been reduced from 40 per cent in 2007 to 36 per cent in 2008, while the allocation to less liquid assets which generate an additional risk premium, such as private equity, real estate and infrastructure. The change has served the PGGM well, with the fund’s 6 per cent allocation to private equity generated returns of 28.1 per cent for 2007, which was11.8 percentage points above the benchmark.

Equally consistent with the fund’s aim to offer fully indexed pensions has been the slight increase in fixed income, including inflation linked bonds, from 30 per cent in 2007, to 31 per cent in 2008 and commodities from 5 per cent to 7 per cent over the same period. The positive performance in the commodities sector, which generated 35.6 per cent over the course of 2007, has proven to be a welcome source of returns in an investment landscape plagued by stock market volatility. Meanwhile, approximately 30 per cent of the interest rate risk in the pension liabilities is hedged via 30-year interest rate swaps. All developed market currency risks have been fully hedged since 2000.

This is not to say that the asset manager has been complacent about the recent market turmoil. Indeed, underneath the relatively small ALM adjustments, several far more substantial strategic changes to the fund’s future asset management style have been put in place ever since the credit market turmoil first broke.

Often credited for being one of the first European pension plans to introduce alpha and beta separation into its asset management style, PGGM is a firm believer in the concept of separating manager skill from market risk and return. In 2006, the asset manager replaced its traditional investment organisation of equities, bonds and real estate by a model distinguishing between returns on liquid markets (beta), alternative and illiquid markets and surplus return on liquid markets (alpha).

Two years into the strategy, however, it became clear that the balance of returns within the portfolio was firmly tilted towards the beta side of its portfolio. For the full year 2007, the underperformance of active share strategies and overlay managers cost the fund hundreds of millions of euros in negative returns, a result significant enough to warrant action.

“Since the onset of the credit crisis, we have taken a good look at the historic contribution of long only alpha managers to our portfolio and realised that, especially after fees, this contribution has been minimal, if not negative,” says van der Ende. “As we do not see this situation improving for the foreseeable future, we have decided to cancel our contracts with most external alpha managers and have downsized our internal alpha team to focus more heavily on beta strategies instead,” says van der Ende.

Without the aforementioned active alpha division, the fund’s €86,3 billion portfolio is now spread over three strategic divisions:

  1. The beta – or index strategies – division aims to replicate strategic benchmarks in liquid markets such as equities, fixed-income investments, inflation-linked bonds and commodities. While passive in essence, the focus is on ‘smart’ beta through careful construction of the underlying portfolio. “While we are cautious about active alpha strategies, we see a lot of potential for active beta replication to outperform market indices,” says van der Ende. “For example, we use a lot of enhanced indices through which we can implement value strategies or other optimising strategies and operative strategies.”
  2. The alternative strategies portfolio, meanwhile, is included to achieve a better risk return profile than is achievable on liquid markets by investing in illiquid assets such as private equity, private real estate and hedge funds. This portfolio also includes PGGM’s portfolio of strategies, a group of dynamic investment strategies, including CO2 emission rights, forestry, insurance risks, volatilities, mezzanine loans and loans to fund projects in emerging markets. “The objective of our portfolio of strategies is to combine several new investment strategies into a minimum risk portfolio that generates a stable return and has low correlation with the current investment mix,” explains van der Ende. “For example, we have invested several hundreds of millions euros in catastrophe bonds as a means of generating a less correlated, diversified risk premium.” The target return for the portfolio of strategies is 370 basispoints above Euribor and in 2007, these strategies returned 11.7 per cent, 2.9 percentage points above the benchmark return.
  3. The third division is reserved for those asset classes where PGGMs internal managers have the expertise to add significant value through active investments. “The fundamental strategies division invests in areas such as listed real estate and structured credit, where we feel we have the knowledge and experience to significantly outperform,” says van der Ende who confirms the division has continued to invest actively in collateralised loan obligations throughout the recent credit market turmoil in order to take advantage of recent attractive premiums.

Taken together, PGGMs approach to dealing with the crisis has served its client relatively well. Total net returns for 2007 stood at 7.1 per cent and after a dip to  minus 2.9 per cent in the first quarter of 2008 – primarily due to negative equity performance – the fund’s second quarter figures are back in the positive, with a total return of 0.2 per cent. This leaves the fund with a nominal cover ratio of 143 per cent, well above the 125 per cent cover ratio required by the Dutch central bank.