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CERN fund: the collision of investment ideas?

Its core business involves expanding the realm of science by beaming particles close to the speed of light and it invented the web – as we know it – as a nice little side project. You would perhaps then expect the CHF 3.6-billion ($3.9-billion) pension fund of the European Organisation for Nuclear Research, CERN, to be bold and innovative.

After a few seconds in conversation with Theodore Economou, the fund’s chief executive, you still can’t help being instantly impressed though by a real determination to break new ground in institutional investing.

“The approach we have implemented could be the ideal investment governance for any pension fund,” Economou says. “We have taken the fund from a difficult situation to setting recognised best practice on a global basis – a model based on the efficiency of transforming risk into returns.”

The story of the revolution brought about under Economou’s stewardship is a fascinating one that starts with a “traditional” risk-heavy fund and ends (for now) with the investment committee monitoring its transformed investments daily with a custom-designed iPad application.

From tradition to revolution

When Economou arrived in 2009, the fund had 60 per cent invested in “risk assets”. While he recognises the reasoning behind this, a calamitous minus 19-per-cent investment return in 2008 left a gaping deficit against the final salary-linked liabilities and left Economou convinced that the model was broken.

Controlling risk became the imperative obsession for Economou and his colleagues. While many pension funds would have decided at this juncture to tweak its existing investment strategy to squeeze out risk, the CERN fund flipped the idea on its head. It first defined an appropriate risk appetite and allowed a “dynamic asset allocation” to run free within that, according to its set of investment principles.

Minimising medium-term losses while allowing the fund to capture enough upside to meet return objectives became the priority in setting the risk budget. This is defined annually and is currently set at a 5 per cent worst-case scenario risk of 8-per-cent maximum investment losses across the fund. As much tinkering with the asset mix as deemed necessary can ensue, provided the risk limit is not breached – something the investment committee will shortly be able to check daily on its iPads.

The asset mix became radically transformed under the new approach. “We now view asset allocation in terms of risk classes instead of asset classes”, Economou explains. Cash holdings of 6.2 per cent form a risk-averse foundation, while the rest of the fund is split into three chunks of a little over 30 per cent each.

An absolute return class is the alpha-seeking part of the trio. It contains the fund’s real estate holdings (on which risk has been reduced by a move into entirely direct holdings), alternative investments and a smaller portion of private equity. Economou summarises its objectives as “strong downside protection with high efficiency”.

On top of that comes an “asymmetric” class of long-only bond and equity investments “managed to a very strict risk discipline” – in other words the CERN fund’s homemade smart beta portfolio. “These strategies incorporate risk-management into what are otherwise traditional mandates”, Economou adds.

Index strategies form the final risk class, offering the “highest upside potential, however with high volatility”. These have been reduced from 60 per cent to 30 per cent of the portfolio in recent years as part of the drive to control risk.

The asymmetric and absolute return classes have both been growing at the same time (from zero and 15 per cent respectively to around 30 per cent).

An active approach has been taken to shuffling the weightings of the three risk classes, just as the management of assets has been transformed from being largely passive to significantly more active.

Over half of the portfolio is now run internally, an approach that Economou says has led to “clear efficiency benefits”. “Going from asset class classification to a complete risk factor allocation is where the industry is going and is one of the next challenges,” Economou says.

Reflecting on the successes of the new investment strategy, Economou beams. “For the past two years we’ve been able to demonstrate we are running a Sharpe ratio in excess of two,” he says. Successfully navigating the 2011 summer downturn is one of the proudest achievements of the new focus on downside avoidance, he adds. The fund is also on track, Economou says, to meet the demanding return objective of outperforming local inflation by three percentage points. It saw returns of 6.9 per cent in 2012, helped by a performance of over 10 per cent on the fund’s equity bucket.

The thinking on returns has been totally changed too, Economou adds. Returns are now judged “against the actuarial return objectives and not against any market-based benchmarks as these don’t appropriately match the many constraints that most boards have”. That is not to say that the CERN fund neglects to make investment calls on the basis of market potential. It is constantly conducting “top-down macro-analysis” to seek investments opportunities. A major recent change is transforming the bond mandates to gain exposure to what Economou terms the “re-rating of the emerging world”.

Risk and efficiency have joined returns though in making the “three dimensions” that the fund measures as part of its “matrix of objectives”. Economou explains: “We want our staff to focus on maximising the rate of conversion from risk into return instead of focusing on a benchmark.” The deficit of the fund remains sizeable with a 66-per-cent funding ratio, but the shortfall has been cut and is projected to narrow further with the current strategy.

Radical new structure

What further distinguishes the CERN fund is the innovations it has embraced to redefine the governance of its investment strategy. Defining the exact purpose of its board is, Economou explains, “allowing our board to express its utility function in terms of risk appetite and return objectives while ensuring the fund is run to these objectives.”

Economou says that focusing the board on these specifics “ensures all assets and performance are controlled by the most qualified entities”. An external risk consultant (Ortec) has been appointed and a single master custodian (State Street) has been tasked with providing daily risk, return and efficiency data. Economou says daily reviews have enabled the fund to gain “greater visibility, has eliminated watch lists and has been able to take action much faster to redeem underperformance and modify allocation”. You get the feeling that as with anyone aspiring to join CERN’s technical staff, only the best need apply for its pension fund’s asset mandates.

CERN’s culture of attracting expertise from far and wide as a pan-European organisation has carried into the running of the pension fund under Economou’s watch, with several external experts drafted in to advise from other funds and the investment industry. The fund has also taken some more direct inspiration from its sponsors, using the same quality assurance procedures that were used in constructing the organisation’s famed Large Hadron Collider. The fact that Economou demanded the Geneva-based CERN fund be brought up to the German regulator’s net asset value reporting standards is another clear indication of its outward approach.

A membership that contains multiple Nobel-prize winners has also been an asset, Economou says. “One of the reasons we have been able to make these changes is that the intellectual firepower of the CERN board made them willing to challenge the status quo on investment strategy and enthused by bringing innovation.” Economou is aware that these changes “are resonating internationally” – proving perhaps that it is not just in physics where CERN is able to make major breakthroughs.

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