Portable alpha slashes pension deficit

In recent years Robert Hunkeler’s investment strategy at International Paper’s $14.8 billion pension fund for employees of the paper and packaging giant has grown increasingly conservative. Today the $9.1 billion defined benefit portfolio is on a de-risking glide path and matching liabilities and fixed income investment is order of the day. But that still gives Hunkeler, who has run pension strategy at the world’s biggest paper company since 1997, ample room for innovation and success.

Like the strides he’s made reducing the deficit in the last three years. The pension fund is now 90 per cent funded on an accounting basis, up from 78 per cent in 2016 and equating to a reduction of pension risk, or the volatility of the funded gap, by around two thirds.

In a multi-pronged strategy the paper giant offloaded $4 billion worth of liabilities, boosted its contributions to the pension fund and shifted more pension assets from risk allocations to long bonds.

It also increased an interest rate hedge via a derivative overlay to 75 per cent in an approach that allows the pension fund to generate a greater return than if it used physical assets to hedge its liabilities.

“It is rational to reduce interest rate risk embedded in a portfolio as best you can, and derivatives give us the advantage of being able to do that while maintaining higher allocations to risk assets,” saysHunkeler in an interview from Stamford, Connecticut, where the investment team of seven is based.

The allocation in the DB fund, divided between stocks (37 per cent) bonds (50 per cent) and alternatives (13 per cent split between hedge funds, private equity and real estate) will stay the same for now.

Only when it’s 100 per cent funded will new triggers kick-in, reducing the equity and alternatives allocations and increasing the hedging ratio again. However, despite the progress of the last three years Hunkeler doesn’t believe the pension fund will be fully funded anytime soon.

“My guess is it’ll take a while to get to a fully funded level: interest rates won’t likely rise much in the near term, returns won’t likely be large either and I don’t think we’ll make any voluntary contributions for some time to come.”

Despite the focus on the deficit the fund still has meaningful equity exposure. The allocation is broken up into US and non-US sectors, the latter comprising an international developed markets allocation and an emerging markets allocation.

The active approach spans the DB and DC funds to the extent Hunkeler only runs one index strategy in the pension fund’s entire equity allocation – a passive portfolio tracking the S&P500 in the DC fund. In the US, allocations are divided by market cap with investments split between large, mid and small cap companies with each bucket divided again between allocations to growth, value and core styles. Another layer of diversification comes from different strategies that span highly quantitative to highly fundamental.

Portable alpha

Portable alpha used to comprise another seam to the equity portfolio, introduced 15 years ago in a flagship strategy for a corporate fund.

“We looked at the excess return we needed from our large cap portfolio to be successful at the total plan level,” he recalls. “US large cap is one of the more difficult markets to outperform and it made sense to port a high alpha product like hedge funds into that area via an S&P index overlay.” The success of the overlay strategy in generating sought-after additional returns led Hunkeler to apply it to other parts of the portfolio next.

Namely the fixed income portfolio – which he describes as the second most difficult place to add value after equities – where he began by splitting the allocation between the S&P500 and the Barclays Aggregate Bond Index. Next, as the fund’s allocation shifted from the Barclays index to more conservative long bonds, Hunkeler began porting over the alpha to long treasuries and has now “completely transitioned” the entire portable alpha strategy on top of the long bond portfolio.

“As we’ve reduced our equity exposure, we’ve gradually transitioned our portable alpha strategy so that it’s now on top of a long treasury overlay. Thus, over the last 15 years it’s shifted from one end of the capital markets to the other,” he says.

The profitability of the strategy has endured the transition.

“Over the last 15 years our portable alpha program has added roughly 180 basis points a year over its benchmark, net of fees, making it one of our best performing portfolios.”

Portable alpha is also a more interesting seam to an investment strategy that has grown progressively more conservative as the pension fund focuses on the fixed income world.An aspect of the job that Hunkeler misses when he reflects on his tenure at the fund.

“Looking at strategies that could generate high returns and high alpha was fun,” he says.

The overlay is managed by NISA Investment Advisors and the alpha generating hedge fund portfolio comprises five to six funds split between fund of funds managers and direct investments. Managers include Blackstone, which has a long-standing relationship with the fund dating from International Paper investing in one of its first ever hedge fund products in the early 1990s. That formative relationship later led to Blackstone designing one of the portfolios in its portable alpha program.

“They liked the idea and developed a hedge fund for it,” he says.

Today, ensuring the hedge fund strategies don’t correlate is a challenge but Hunkeler observes that the correlation of the hedge fund portfolio is much lower to fixed income asset classes than it is to equity asset classes.

“It is working even better now that it’s tied to a long-duration treasury derivative as opposed to the S&P500.”

He also attributes the success of the strategy to not deviating from a core belief that hedge funds are market neutral.

“We are not looking for equity substitutes. We are looking for a portfolio that delivers fairly consistent, lower returns compared to what many other investors seek from their hedge fund allocation.”

Nor does he invest the full notional value of the portfolio in hedge funds to give headroom when the market swings.

“We only invest 90 per cent of the notional value so in periods when a beta of 0.1 goes to 0.6 we are not penalised as badly as we would be if we maintained it at full notional value.”

DC focus

As the need to shoot the lights out on the DB side fades Hunkeler is increasingly turning his expertise and energy into developing International Paper’s fast-growing $5.7 billion savings, or DC plan in a transition phase at the fund.

“We are doing exciting stuff on the DC side. The transition from the DB world to the 401(K) world is allowing us to bring all the learnings and skill from the DB world over to the DC side.”

That transition has involved “white labelling” many of the DB pension portfolios, making them available to savings plan participants in a process begun in 2002.

“Our savings plan core options are essentially the same portfolios we use in our pension fund; they are investing side-by-side,” he explains.

In a bid to complete the process he is now exploring adding most of the risk-based investment options in the DB fund to the savings plan although savings plan participants won’t get access to portable alpha and hedge funds “for now.”

Not only will it give savers more investment options and a chance for better returns. It will also increase manager diversity. The DC fund currently offers a three-tiered investment structure where in tier one, employees can choose from three well diversified portfolios of stocks, bonds and real estate, ranging from conservative to aggressive. These portfolios are managed by a single manager; mindful of single manager risk, white labelling the DB fund will increase manager diversification.

“We plan to allow the savings plan participants to benefit from the same value-added performance that we’ve generated on the DB side.”

Hunkeler outsources all asset management to around 75 managers that together run around 160 separate portfolios. But consultancy Rocaton, also in Connecticut, helps with every aspect of strategy from asset allocation, LDI, manager searches and performance evaluation and is his first port of call. “Rocaton acts like an extension of our internal staff,” he says. “Managers always try to come to us; we always redirect them to Rocaton.”

Hunkeler also attributes much of the fund’s success and advantage to a governance structure that has delegated control over every important investment decision. It’s led to his conviction that governance by committee, where often in-expert members must approve every aspect of strategy and manager selection, is highly damaging.

“Investment management decisions should be left to those living and breathing them on a day to day basis; to not do so can lead to misalignment. It’s easy to see how committees move to conservative and safe decisions that rarely lead to outstanding performance,” he concludes.