The NZ$33 billion ($22 billion) New Zealand Super is looking to increase its exposure to equity factors while also implementing the next phase of its climate strategy, which includes decarbonising its existing equity factor mandates.

About three-quarters of the fund’s portfolio is passively managed and the use of factor strategies is aimed at getting more out of the passive portfolio.

Specifically, NZ Super is looking to appoint an additional manager this year with a focus on multi-factor strategies.

A spokesperson says: “All mandates with existing (and future) equity factor access points are flexible, and can be sized up or down as required by our views on opportunity attractiveness, assessed several times a year.”

The fund has existing factor mandates with AQR and Northern Trust, both for low volatility and value.

NZ Super moved its global passive equities portfolio to low carbon last yearand now climate change-related exclusions have been implemented in its externally managed emerging-markets mandates.

The investment committee also recently approved a framework for investment professionals to incorporate climate-change considerations into valuations. The next move is to focus on decarbonising the existing equity factor mandates.

The fund is working on releasing a carbon footprint for the portfolio for the financial year just ended.

NZ Super chief economist Mike Frith says the fund is strongly weighted towards growth assets, but the overall use of active risk remains comparatively low.

“This reflects our view that many assets are fairly valued,” Frith says. “It reflects the low use of risk by those strategies that respond to changes in the market environment, like the strategic tilting program.”

The strategic tilting program is one of three value-adding activities in which the fund engages. The other two are capturing active returns and portfolio completion.

The fund has made a number of other new investments in the last six months.

In October last year, it purchased a stake in Australian beef stud Palgrove, which was the fund’s first offshore investment under its rural land strategy. It now has 33 farms, worth $340 million, in its rural land portfolio.

NZ Super also increased its allocation to natural catastrophe bonds, managed by Leadenhall. The mandate is managed as a separate account to give the fund flexibility to respond to changing market conditions. It typically changes several times annually.

Earlier this year, NZ Super, alongside CDPQ Infra – an infrastructure-dedicated subsidiary of $238 billion Caisse de dépôt et placement du Québec – submitted an unsolicited proposal to the NZ Government to develop, construct, own and operate the Auckland Light Rail project on a commercial basis.

CDPQ Infra is responsible for developing, building and operating a 67km light rail network that is under construction in Montreal. About 2 per cent of NZ Super’s portfolio is in infrastructure.

As at June 2018, the fund’s other asset allocations include global equities (66 per cent), fixed income (10 per cent), timber (5 per cent), private equity (5 per cent), NZ equities (4 per cent), other private markets (3 per cent), property (2 per cent) other public markets (2 per cent).

“We are well positioned to benefit from the underlying economic outlook,” Frith says. “But we expect more normal performance from the fund in future, rather than the very high returns we have had.”

The fund returned 13.2 per cent in the year to May 2018. The reference portfolio returned 10.7 per cent with the active return from investments adding another 2.5 per cent.

A case study that looks at University of California Investments’ reporting of illiquid asset valuations shows how large institutional investors can use data science to improve operational efficiency.

Specifically looking at innovation in fair value of illiquid assets, the case study details how fair value quantities can be improved and extended for limited partners (LPs) both in terms of accuracy, timeliness and granularity. But the purpose of the case study is to show the value of bringing sophisticated data tools inside a long-term investor.

In the paper, “Data Science: a case for innovation in valuation”, the authors, from the University of California, Stanford University and FEV Analytics, seek to demonstrate how “adoption of advanced data science techniques can move organisations past the current unsatisfactory state of the art, to an unprecedented level of operational finesse”.

Sheridan Porter, head of marketing at FEV Analytics and researcher on the paper, says LPs need to get started with data science.

“It is inevitable that the industry will move towards using data science,” she says. “LPs need to get started or they will be at a disadvantage to their peers in five years.”

The paper provides LPs clarity on what data is needed, how it should be handled, and the business case for its rigorous application.

The case study

The $120 billion University of California Regents has about 9 per cent allocated to illiquid assets, and like many of its peers, has under-developed technical tools. As such, the authors say, the organisation could show incredible improvement with small changes.

The case study looks at how data technology can streamline and strengthen portfolio fair valuation of illiquid assets and produce additional benefits for the investment team outside of operations.

General partners typically report asset values quarterly, but their reports often have months of lag. This creates an opaque and complex environment for LPs, who are required to report the fair value of their investments objectively and ahead of their GPs.

The commonly used “roll forward”, which takes the most recently reported GP estimate of fair value and adjusts it for the accounting period, is flawed – not least because it is a manual process.

The new technology the case study showcases makes the roll forward more exacting and systematic, overcoming the limitations that make fund valuations unreliable. Where richer data is available, such as in co-investment portfolios, the technology automatically expands the set of outputs, creating a valuation independent of GP reporting.

“The conventional roll forward procedure is a practical workaround to a difficult issue, but its manual nature makes it unreliable,” Porter says. “As a result, it’s typically done just once a year as a reporting procedure, rather than quarterly or monthly as a monitoring or risk-management procedure. The innovation moves roll forward into another realm, where systematic daily valuation is possible.”

The coded statistical approach to the roll forward, introduced in the paper, operates at the holdings level, the accuracy and reliability of which are explicitly captured and aggregated to the portfolio level. Data pathways automatically adjust the methodology according to the information available on each fund, meaning LPs don’t need to make data uniform across a portfolio before operationalising it.

“It’s a massive computation, done within hours,” Porter explains, “It makes all parts of the roll forward procedure – including the market adjustment – systematic and automated. These are necessary conditions for it to scale and be accountable to quality standards and stakeholders.

“As portfolios and the expectations of in-house teams evolve, this type of measurement is useful because it connects a valuation process to a risk-management process.”

The automated approach eliminates the lag that is common in private asset reporting. It’s not out of the question for a valuation to have a six-month lag, which can have a big impact on the portfolio if the projected and actual valuations are significantly different.

Practical advantages for LPs

“Measuring asset value, independent of the GP, gives the LP some very practical tools,” Porter says. “For example, a difference in our measure and the GP’s estimate might indicate a stale NAV [net asset value], the largest of which can be prioritised by the LP for discussion with the GP. We can work the technology to streamline operational processes and leverage that for the LP to speak to the GP.”

The paper shows that there are also other benefits for LPs using measurements that do not have a lag.

“If LPs can see granular portfolio valuations on a more frequent basis, other portfolio measures related to liquidity, market sensitivity and performance also become available on a more rolling basis,” Porter explains. “Portfolio manipulation and look-through are core components of investment operations.

“For CIOs, this brings the [alternatives] portfolio in off its island, makes it synchronous with other asset classes. It has real implications for asset allocation as well as operations.”

The paper, written by Arthur Guimaraes from the University of California Investments, Ashby Monk from Stanford University and Sidney Porter from FEV Analytics, will be published in the fall edition of the Journal of Portfolio Management.

It can be accessed here: Improving-investment-operations-through-data-science-a-case-study-of-innovation-in-valuation

 

 

 

Simply put, Graeme Miller believes the primary driver of value in a superannuation fund’s investment portfolio is asset allocation decisions.

It’s no surprise, because Miller, chief investment officer of the A$21 billion ($16 billion) TelstraSuper, spent most of his nearly 30-year superannuation career in investment consulting, culminating in a role as head of investment consulting, Australia,
for Willis Towers Watson.

He is now just over two years into performing the top investment job at Australia’s largest corporate superannuation fund, and the biggest change he has made to the team and investment process is to establish a “well-resourced” asset allocation team.

“TelstraSuper has a good track record of adding value through asset allocation and dynamic asset allocation calls,” Miller says. “But the process was largely based on the views and judgements of the CIO and narrowly supported by others as an adjacency to their roles.

“Given the importance of it, I wanted to have dedicated people in that role and we thought carefully about how to structure that.”

David Schneider, who worked at UniSuper for 10 years, joined TelstraSuper in January as head of asset allocation. Including him, there are now four investment staff members dedicated to strategic and dynamic asset allocation.

Schneider’s team does the research and analysis to support asset allocation changes, which are then debated by a newly established asset allocation committee, which includes all the heads of asset classes. John Eliopoulos is chair of the panel.

“Before an asset allocation change is made, it is debated and the heads of asset classes give their deep domain input,” Miller explains. “Then the committee collectively reaches a decision. All senior members of the team are involved and encouraged to contribute and challenge. It is important those allocations are supported and tested by the team.”

Miller emphasises the importance of this not only from a cultural perspective – so the whole team makes and owns the decisions – but also from a total portfolio perspective.

“We are delivering aggregated outcomes, not individual portfolios, to members,” he says.

TelstraSuper has a well-developed governance structure and Miller and his team do not need to go to the board for asset allocation changes.

“Under the delegation structure, the investment committee has substantial delegated authority for dynamic asset allocation changes,” he says. “I don’t feel in any way constrained by the governance.”

Current positions

There are a number of asset allocation tilts in play, relative to the fund’s strategic positioning, most of which relate to making the portfolio more defensive.

“This reflects a somewhat cautious view of the level of valuations in the market,” Miller says. “We are not in the camp that is bearish for global economies, we think there are a number of powerful drivers for global economic growth. But we are in the camp that says that is already fully reflected in asset prices, so we think the risk to asset prices is skewed to the downside, which means we have taken a number of steps to make the portfolio more defensive.”

The fund is underweight equities and has also sold off some of its real assets.

“We have taken the opportunity to sell some of the real assets we own and lock in very strong returns. It’s at the margin, and very targeted and deliberate. We are making sure the portfolio is resilient but also that the assets we do sell are the least well placed for how the global economy is likely to evolve.”

The fund is also holding more cash than it ordinarily would. Some of this is from the reduction in equities and the real assets sales, but it’s also the result of an exposure to fixed income that’s lower than normal.

The tilts sit under the dynamic asset allocation choices, but the decisions to hold specific assets within portfolios remain portfolio construction decisions.

This includes tilts towards, or away from, certain industries. An example of this is within renewable energy; Miller points out the fund would much rather own a sustainable low-cost energy producer than a fossil-fuel power generator.

Big-picture themes, such as disruption, are considered by the team, and TelstraSuper recently conducted a comprehensive study on disruption, led by Miriam Patterson, head of real assets.

“This looked at a number of themes, but energy disruption is the one that rose to the top,” Miller says. “The rapid decline in the cost of producing renewable energy and the trajectory of reduction in the cost curve is really fascinating. People don’t appreciate how fast and far the technology has come in the renewable space.”

Such a deep study revealed some detail on how to invest in the space, and Miller says because the price point is moving so quickly, it would be better to invest in the distribution not the generation of energy.

“Owning distribution infrastructure is a more resilient way to play it, and just one anecdote we’ve been looking at with regard to disruption,” he says.

Another example is the disruption of traditional shopping malls and department stores, and the impact of logistics and online shopping on real estate.

Money where its mouth is

TelstraSuper believes in active management; most of the portfolio is actively managed.

About two-thirds of the active budget is spent on traditional approaches, such as stock picking. Now, dynamic asset allocation is also framed relative to the other parts of the active-management program.

“Done well, our dynamic asset allocation will [use] one-third of our active risk budget in the fund,” Miller says.

TelstraSuper is prepared to put its money where its mouth is in terms of its return expectations from dynamic asset allocation, and has articulated the expected value add from the program.

“Over a full cycle, 5-10 years, dynamic asset allocation should add 50-70 basis points above the benchmark,” Miller says.

With the current size of its positions, however, the fund is not taking enough risk to make that a reality.

“I’ve encouraged the team to look carefully at how to spend the active risk budget,” Miller says. “The case for investment has to include active risk, fees and returns. Sometimes, the case for investing isn’t as strong and our members are better off if we spend those dollars in a different way or not at all.”

Active currency management is an example of how the fund is willing to make changes. In the past, TelstraSuper had a big currency overlay but that has been reduced and the fund has changed its thinking in this area. Traditionally, it was managed at an asset class level. But about a year ago, the fund started managing currency at the whole portfolio or investment option level.

“At the overall option level, we now look at what the desirable level of currency exposure would be,” Miller says. “We look at the likely risk/return outcomes of that and ask the same questions as for any exposure to any asset class. We target currency exposures independent of physical assets we hold in that option. It’s a commonsense way of looking at things.

“Previously, the actual foreign exchange exposure was an outcome of the hedge exposures in asset classes, our currency exposure just fell out of that. Now we are more targeted in allocating forex exposures, and the asset allocation team looks at that.”

The fund uses internal resources to make decisions around currency and an external manager to implement them. It also adopts this hybrid in real assets.

“We have a couple of portfolios that we manage totally in-house but in real assets we have a very successful hybrid model. This means we retain the ability to influence the way the portfolio evolves and the transactions in it, but we have a manager implement it,” he says.

TelstraSuper has about 90 manager relationships. Miller says about one-third of those are legacy relationships in closed-end private market and real-estate funds and are going through a natural winding down. That leaves about 50 to 60 active, ongoing relationships with managers.

Miller observes that the trend in the industry towards fewer managers and larger relationships will probably resonate at TelstraSuper but the fund does not have a set target.

“We recently terminated an Australian equities manager but rather than replace them, we decided we would be just as well off distributing the assets across existing managers and getting economies of scale,” he explains. “An undeniable trend, and one we’re very supportive of, is for funds to leverage their relationships with fund managers. There is so much intellectual capital embedded in our fund manager partnerships and having a smaller number of larger relationships allows us to more effectively exploit that intellectual capital.”

Perhaps due to his time as a consultant and exposure to hundreds of managers, Miller has quite a profound view of how managers will need to add value, and model themselves, to thrive.

“The traditional fund manager model is challenged,” he says. “If you’re a well-resourced partner engaged for a specific role but can add value across the portfolio, that gives increased relevance for the manager. If the only source of value it can bring is narrow domain expertise, that’s a big risk to the manager itself. As pressure mounts on fees, managers are in a better position to negotiate if they can offer more.”

Fees and costs are an important focus for Miller and his investment team of 20.

“Far and away the most important thing we are focused on is returns net of fees for our members,” he says. “We are always looking at how much value we are deriving from what we’re spending.”

This is also the lens the fund looks through when it is deciding whether to manage an asset internally or externally.

“There is much more value for money spent internally. We spend about 20 times more on external management,” he says. “We will always be heavy users of external managers but they have to present a compelling value proposition and not all do at the moment.”
Miller is challenging his team to see itself as an investment management organisation, rather than an investment department of a super fund.

“I challenge the team to operate in the way a world-class fund manager would in everything we do,” he explains. “For too long, super funds and consultants haven’t thought of themselves in the same frame of reference as investment managers, and they have sold themselves short. They have thought that a dollar spent on external resources and agents is different to internal systems, processes and people. When you look through a value lens, it is almost always the case that an internally spent dollar will generate a multiple of external dollars.

“We aim to challenge our thinking and culture and ask if this is the way a world-class investment management institution would do it. If not, why? Sometimes we can’t, because of resources, but other times it’s because of a frame of reference. We apply the same principles to ourselves we expect from external providers.”

Last year, the HSBC pension scheme stepped up the pace on de-risking its £27.5 billion ($36 billion) defined-benefit fund for the bank’s UK employees. It sold more than half of its equity allocation in two equal tranches in June and December, cutting the fund’s exposure to developed market stocks from 17 per cent to 7 per cent and reallocating to long-dated, matching assets.

The pension fund hasn’t publicly revealed its latest funded level yet, but chief investment officer Mark Thompson says it is up from the 102 per cent posted in 2014, and the time was right to take more risk off the table.

“There are no prizes for taking on more risk than you need,” says Thompson, who also oversees the bank’s £3.5 billion ($4.5 billion) fast-growing defined-contribution scheme.

In a strategy that will increasingly replicate an annuity provider, Thompson aims for all the pension fund’s defined-benefit assets to comprise long-dated government bonds, long-dated, high-quality corporate debt and illiquid, long-dated matching assets within the next two or three years.

In the latter, allocations will include more assets in long-lease property, renewable infrastructure and commercial ground rents that throw off a good cash flow, have liability matching characteristics and have a high illiquidity premium.

Around two thirds of the portfolio is in matching assets and third is in the return seeking portfolio comprising equity, private equity, corporate credit, global sovereign credit and European government bonds. Strategy also includes taking out all “unrewarded risk”, which means hedging interest rate, inflation and currency risk.

Thompson predicts the annuity-like strategy will shave 25 per cent off the current running costs of the fund, as management fees fall with the reduction in allocations to return-seeking assets.

“Although we will be paying more for the illiquid portfolio because it is actively managed, the running costs of the scheme will fall as we get closer to this target-matching portfolio,” he says. “Rather than beating up fund managers in terms of costs, the reduction will come from the strategic change in the asset allocation.”

Creating sought-after assets

Building up a portfolio of long-dated matching assets involves a proactive approach to sourcing. Rather than wait for sought-after, illiquid assets to come up for sale, HSBC is creating them itself. An example is its remodelling of a long-held commercial office block in south London into a residential property. The transformation will shift the asset out of the return-seeking portfolio into the matching portfolio.

“We’ve got a tenant going in on a 20-year Retail Price Index (RPI) lease,” Thompson says. “We’ve, in effect, turned the asset into a bond.”

In a similar approach, HSBC is investing in strategies run by Alpha Real Capital. The manager creates opportunities in commercial ground rents by approaching corporations keen to restructure their balance sheet and free up capital by selling off the freehold (the building and the land the property sits on) on a long lease.

“Our manager focuses on [corporations] like nursing homes or hospitals,” Thompson explains. “We get the ground rent from the underlying building and it’s well capitalised. If the business fails, we would own the property; these types of deals don’t exist until they are made.”

All management is outsourced to about 25 managers. Thompson oversees an internal team of three, and is hiring a fourth, who focus on strategy. The ability to build up the matching portfolio rests on strong manager partnerships, relationships that have been built up over time and have adapted to the fund’s changing needs.

HSBC’s property manager LaSalle, for example, used to manage the pension fund’s £1 billion return-seeking property portfolio, which is now morphing into a matching allocation.

“The mandate has changed dramatically from what it was five years ago,” Thompson says. “Our manager relationships are based on understanding what they are good at, and our managers understanding what we need. It evolves through time.”

The dynamic relationship is reflected in other ways, too. When Thompson joined HSBC seven years ago, external managers attended the pension fund’s investment committee meetings, something he stopped because managers’ presence used to crowd out talk on strategic issues. Now, Thompson tends to hold lengthy meetings with his peripheral external managers a couple of times a year in their offices, balanced with much more regular contact – weekly in some cases – with his core managers.

“The job of my team is setting strategy like a conductor of an orchestra and then making sure all the fund managers play instruments correctly,” Thompson says.

HSBC’s fund managers are also an important source of innovation, evident in the scheme’s adoption in 2016 of a multifactor global equities index fund that incorporates a climate tilt. HSBC designed and funded the vehicle, which is managed by Legal & General Investment Management.

“We will come up with half an idea, the consultants have half an idea and the managers will add to it, and between us all it ends up being a good idea,” Thompson explains. “The kernel of a good idea always gets polished up by discussing it with our fund managers.”

Fees are constantly under review, but he doesn’t believe “in going to a manager every five minutes” to hammer down fees. Once a year, Thompson takes details of management fees to his investment committee for approval.

Governance allows much-needed agility

The de-risking trajectory requires an ability to act quickly, something HSBC’s governance allows. When the fund decided to reduce the developed-market equity allocation from 17 per cent to 7 per cent last year, the first 5 per cent was taken out after just one board meeting.

“We had a board meeting; it was agreed that it was too important to wait until the next meeting, so we did it,” Thompson recalls. “If I need an investment committee meeting, I can have one straightaway as long as everyone is around. I don’t want our investment process confined to a quarterly cycle, because we might need to react quickly and need flexibility in the system.”

The human brain is extraordinary, and it doesn’t always work the way we think it should. For example, I have yet to meet someone who can rotate their right foot in a clockwise direction and simultaneously repeatedly draw in the air with their right index finger a large ‘6’. (I know you are trying it right now, and I also guess that you may be laughing that your foot inadvertently turns anti-clockwise.)

My fascination with how the brain does, and doesn’t always, work –this applies as much to investment as anywhere else – has led me to fly the flag for behavioural economics.

150 different biases

Around board tables and within committees, human biases can lead to sub-optimal decision-making, so understanding key aspects of social psychology is an important defence against what is often referred to as “group think”.

Psychologists estimate that the human brain is potentially subject to more than 150 different biases – some of which make perfect sense from an evolutionary perspective but may sometimes be inappropriate in the modern business world. Common examples include the bandwagon effect, overconfidence and the optimism bias.

A lesser-known, but equally challenging, bias is ‘the halo effect’. The term was first used by psychologist Edward Thorndike in the 1920s, as he sought to explain a bias present in how military commanding officers judged qualities in their subordinates. His conclusion was that humans perceive the quality or skill of a person in one area based upon how they perform in another area. Thorndike originally applied the term to people; however, its use has been greatly expanded to include businesses and brands.

Professor of psychology Robert Cialdini says other simple examples of the halo effect include the way “we automatically assign to good-looking individuals such favourable traits as talent, kindness, honesty and intelligence”. This is why celebrities are used to endorse products. We are more likely to buy a brand of coffee if George Clooney is associated with it. But why should consumers want to buy a brand because it is associated with a movie star? This makes no sense from a purely rational perspective. It shows the power of the halo effect.

Phil Rosenzweig exposed how such thinking pervades the business world in his provocative 2007 book The Halo Effect,in which he pulls no punches describing how most commentators are systematically delusional when it comes to picking theories about the reasons for strong company performance. For example, one unconsciously assumes that a measure of success such as share price performance or profits must directly reflect good strategy or top-quality management. There is little room, the assumption goes, for luck or subtle shades of grey. And if an overall impression of a company is favourable, then thoughts about all aspects of its make-up are likely to be seen as consistently positive.

Put simply, Rosenzweig believes we too often have pseudoscientific explanations for business performance.

As noted, the halo effect equally applies to individuals, corporate brands, investment teams – even music. Diehard fans of The Beatles will tell you they never made a bad record but listening to Revolution #9 on the White Album is the best way on the planet to waste 8 minutes and 22 seconds of your life.

How to dodge the pitfall

How can we avoid falling for this cognitive bias? In a nutshell, we need to examine the evidence objectively and independently and try to avoid confirmation bias.

A model that works well for some investors and companies is not necessarily the correct one for others, nor indeed for the future. As the brilliant professor Costas Markides of the London Business School tells his senior executives, “Stop thinking out of the box, because there is no box. Just ask yourself three simple questions: Who is your customer? What is the benefit to the customer? How should I sell it?”

Only then can you decide on the right strategy for your organisation. Investment is rarely formulaic. And don’t assume today’s winners will even be playing the game in a few years. As behavioural economist Daniel Kahneman wrote, “If people are failing, they look inept. If people are succeeding, they look strong and good and competent. That’s the halo effect.”

Self-awareness trumps best-selling advice

Things change but the halo effect will remain as long as we are human. People will keep buying the latest business management book assuming it will contain a scientific formula for success. There’s a joke that if you read just two books, What They Don’t Teach you at Harvard Business Schooland What They Teach you at Harvard Business Schoolyou must, by definition, have read the sum total of all human knowledge.

The truth is that no investment or business management book can provide you with anything other than a modicum of true wisdom. For example, one should be skeptical of any text claiming to be able to define what makes a successful investor, company or great chief executive. Such judgements are so prone to general survivorship bias and the specific heuristics of that author that a different writer could theoretically argue the opposite view. Evidence is often filtered to the point that what looks superficially convincing may be little more than pseudoscience.

As someone who believes improving people’s self-awareness and self-discipline are two keys to success in most things, I think the best way to close the gap between potential and performance is unlikely to be found in this year’s business best-seller, which will be stuffed full of examples of the halo effect.

We would do better to concentrate on our own abilities, through a better awareness of our own biases, coupled with various self-discipline behavioural techniques that can mitigate mistakes and enhance skill, whether in investment, business or life.

As I note in my TEDx talk and training masterclasses, the key reason to promote behavioural economics in the investment and business world is that it can provide individuals and firms with a competitive advantage by recognising and mitigating some of our mental shortcuts, including the halo effect.

Above all, behavioural economics emphasises the importance of challenging our hardwired biases and much of our traditional thinking to optimise our chances of reaching better conclusions. Nowhere is this more important than in the world of investment. We need to question our assumptions.

I have always, therefore, liked the John Maynard Keynes quote: “When the facts change, I change my mind. What do you do, Sir?”

 

Paul Craven combines his love of decision-making, investment and psychology to promote the importance of behavioural economics.

 

Strategy at the Dutch €26 billion ($31 billion) PGB Pensioenfonds centres around dynamic asset and liability management. The fund’s matching and return portfolios, and an interest-rate hedging strategy, all move in line with its funding ratio.

It’s a careful balancing act that involves protecting the fund’s liabilities while keeping sufficient risk on the table to capture the returns to maintain an enviable 108 per cent funded status, up from 100 per cent in 2016. Last year, the fund returned 6.7 per cent.

“We adjust risk according to our funded status,” chief investment officer Harold Clijsen says. “When our coverage falls below 105 per cent, we dial back on risk, and when it is above 125 per cent we also dial back because there is enough money on the balance sheet to meet pension promises.”

Clijsen uses a strategic framework to adjust the equity, interest rate and credit risk, in a process that measures the risk premia of the different assets and takes momentum into account.

“When the risk premia and momentum are high, we can add risk to the portfolio; when the risk premia is low and momentum is also low, we have a lower risk allocation to certain assets,” he says, referring to today’s market to illustrate the strategy in action. Although risk premia is low across most assets, momentum is diminishing but still positive, so Clijsen is paring back equity risk.

“I am concerned that we might not be fully compensated for our risk exposures in the long run and scaling back in equity is the easiest way to adjust the risk budget.”

Success with interest-rate risk

Within this strategy, PGB’s dynamic approach to interest-rate risk has proved particularly successful, contributing 1 per cent to the fund’s returns over the last two years. It follows the same pattern as the strategy for equity and credit risk: when interest-rate risk is low, the fund calculates a lower risk budget and reduces its interest rate hedge; when rates move higher, Clijsen increases the hedge.

“If rates go above 4.5 per cent, 80 per cent of the liabilities will be hedged,” he says. The interest rate hedge at the end of 2017 stood at 45.2 per cent of the pension fund’s liabilities.

The fund’s assets are split 55/45 between a return and matching portfolio, respectively.

The matching portfolio comprises low-risk fixed-income investments, which are intended to keep pace with changes in the value of the pension commitments. They span European government bonds, rate swaps and futures, investment-grade credit and mortgages.

About 47 per cent of the return portfolio is in equities; other allocations include higher risk fixed-income assets, such as dollar denominated emerging-market bonds, plus real estate, infrastructure and a small allocation to private equity.

All management of the €14 billion ($16 billion) return portfolio is outsourced but the matching portfolio is mostly run in-house. Clijsen believes it is more efficient to outsource the return portfolio to professionals with systems and expertise than to build an internal team; he also seeks to avoid the operational risk of internal management.

“It is very difficult to compete with external managers in active management and we would rather have the flexibility to change managers than run an internal team,” he says.

In contrast, he likes contact with the market in the matching portfolio, where strategies are buy and hold and it is much easier to match liabilities internally.

The investment team of 28 is split into four groups: strategy and ESG integration; the matching portfolio; manager selection; and a legal division.Last year, the fund’s total investment costs were 47 basis points, coming in below the 55-basis-point average for Dutch pension funds. PGB achieved this, Clijsen says, by managing the fixed income portfolio internally and employing large passive and factor mandates in the equity portfolio, which costs less than using a fundamental approach.

Most of the equity allocation is in Europe and North America, with smaller allocations to Asia-Pacific and emerging markets, managed passively and actively. The factor allocation is confined to developed markets and comprises low volatility, value and momentum mandates. Clijsen is in the process of adding quality, and possibly one other, new exposure, which will boost the factor allocation to 35 per cent of the equity portfolio. He likes the way it is possible to attribute returns to specific factors and the cheaper cost of factor mandates, compared with traditional active management.

Other strategies that he says are working well include the mortgage allocation, which is still delivering returns above swap yields. He is researching whether put options would give the equity portfolio additional insurance from more extreme movements. He is also planning to increase the alternative fixed income allocations.Also, to begin meeting the UN’s Sustainable Development Goals, Clijsen is exploring building an allocation to small or mid-size buyouts in private equity that prioritises impact investment funds.

“We are investigating how to combine these two themes, particularly focused on energy transition.”

 

Benefiting from Dutch consolidation

Clijsen prefers fixed manager fees to performance fees, and seeks alignment with managers by building long-lasting relationships. PGB has particular clout negotiating fees because of the growing tail of larger pension funds joining the scheme as part of the consolidation in the Netherlands’ pension sector.

The number of Dutch pension funds has fallen from 1000 18 years ago to about 250 today, as smaller have switched into industry-wide schemes or liquidated. When Clijsen joined PGB in 2014, the fund, which originally provided pensions for the graphic arts sector but is now multi-industry with 2434 employers, had assets under management of only €14 billion ($16 billion). That amount has nearly doubled since then.

“Every time a larger company pension scheme joins PGB, we have another way to renegotiate investment fees,” Clijsen says. But he worries that pressure on the fund to keep fees low could affect PGB’s ability to diversify into lower risk, but expensive, alternatives. The way around this is to ensure robust communication with beneficiaries, he explains.

“It is important to explain to our beneficiaries why we are allocating certain fees to certain asset classes and the need for different beta returns.”

Indeed, every three years, PGB consults its beneficiaries across all age groups and its multiple employers.

“We consult with our beneficiaries to see how they think about their pension and what they would like to see in the portfolio,”he says.

It’s a consultation process that recently led to excluding tobacco and controversial weapons manufacturers and is also behind the drive for ESG integration at the fund, which began to formulate a climate policy at the beginning of 2018.