The giant Dutch pension fund, ABP with €300 billion ($456 billion) in assets, is considering using smart beta benchmarks. While APG, which manages ABP’s assets has been using smart beta strategies for implementation for three years, the fund is taking it a step further and is now considering tilted benchmarks. Amanda White speaks to head of investments of the executive office at ABP, Jeroen Schreur.

 

The general pension fund for Dutch employees, ABP, is in good shape. It now has a funding ratio of 105.9 per cent and it can remove last year’s pension reduction (of 0.5 per cent).

With a long-term strategic asset allocation split broadly 60:40 the board, and executive committee, concentrates on diversifying that broad asset mix, reducing investment costs and finding better ways of implementing its policy.

For the past 10 years the long-term investment policy hasn’t changed much, with the asset allocation done within a risk framework based on the asset-liability study. (see asset allocation below).

Head of investments of the executive office at ABP, Jeroen Schreur, says there has been a slight shift in the asset allocation, and for the three-year period from 2013-2015 the fund has increased its strategic allocation to global equities and emerging markets by a collective 4 per cent; this offset by a collective 4 per cent lower allocation to real estate, GTAA and infrastructure.

“This change has partly to do with our size,” Schreur says. “From 2010-2012 our weight of equities has grown. In order for us not to sell – we’d be forced to sell to rebalance – we have made some smaller changes to asset allocation to bring in line the portfolio.

“The actual portfolio looks a bit different to the strategic asset allocation and we try to not be mechanical about rebalancing but look at the best way to rebalance, sometimes being forced to sell equities is not the best thing and it’s better to be overweight, versus the norm, for a little while.”

The investment executive office within ABP, which only has four employees, advises the board on policy, and works with and monitors APG on the investment implementation of the investment policy.

Schreur says that his office is always working on the details of the investment plan. In addition to the strategic investment plan every three years, a new plan is drafted every year looking at economic scenarios, contingency scenarios, constraints, bechmarks, hedging policies, ALM statistics ant implementation.

This annual review takes on different topics, including this year a discussion about the new regulatory framework within The Netherlands and the potential impact on discounting liabilities and inflation aspects of the contract.

Another topic under investigation this year is the idea of smart beta benchmarks.

ABP, via APG has been implementing the strategies that broadly fit under the smart beta umbrella for about three years.

In an interview in April last year, Ronald Wuijster chief client officer at APG Asset Management explained to conexust1f.flywheelstaging.com the practice started in commodities, where it excluded some of the commodity classes, such as natural gas, that have certain behaviours, in a bid to have a more optimal beta exposure.

And in its equities exposure, the fund has more than 50 tilts along the “quant spectrum”.

Between 50 and 60 per cent of the developed markets equities exposure is managed using quant strategies and APG has tilted for value, momentum, quality, fundamental indexing, and risk.

“We created a separate asset class for minimum volatility, and we are now researching to allocate to credit and emerging market equities in that. Clients can allocate to that building block,” he says.

APG also applies smart beta to real estate and in particular looks at the environmental spectrum in direct property, overweighting to environmentally friendly buildings.

Similarly, in the fund’s credit analysis, it will look at minimum volatility and quality strategies, and is increasing the focus on quality companies.

“Valuation is relatively basic but the majority of investors don’t pay attention to it; they favour glamorous stocks and that’s accepted because of the short-term pressures,” he says. “Many investors are talking about smart beta, but there are not many doing it. The ideas are less than half the exercise; it is hard to execute and implement. We are well advanced but we could also do more; we are still trying to think of new ways.”

Now ABP, headed by Schreur in close consultation with APG, is undertaking a project about the appropriateness of using smart beta benchmarks.

“We are investigating it as part of the investment plan for next year,” Schreur says. “We are working with APG, providing more analysis and facilitating debate with the investment committee.”

The work is beginning with developed market equities, and examining the appropriateness for each asset class.

“For some asset classes, it may not add value or there are a number of definitions of smart beta benchmarks.”

ABP is also working closely with APG to monitor the costs of asset management.

“There is a trade-off between return, risk and cost and we are looking at cost-effective implementation of our investment policy.”

For example APG is currently looking at building its own private equity team, in a bid to reduce costs and move away from a fund-of-funds structure.

APG has managed ABP’s assets since it was created in 2008 when the board of trustees and management company split.

The investment part of the ABP executive office has four staff including Schreur and has specialist functions including risk management, policy development, and legal aspects to assist the board of trustees.

“We have a very long term relationship and contract with APG and we are not looking to change that. We do work with them intensely when they want to make important changes. For example at the moment private equity is managed externally and we are monitoring how closely APG is building expertise inhouse,” he says.

 

The ABP strategic asset allocation is:

Developed market equities         23%

Emerging market equities              8%

Real estate                                             9%

Infrastructure                                     3%

Private equity                                     5%

Hedge funds                                         5%

GTAA                                                      1%

Commodities                                       4%

Opportunities                                      2%

Government bonds                         14%

Index-linked bonds                          7%

Corporate bonds                              16%

Alternative inflation                         3%

 

 

 

 

This paper by the Federal Reserve Bank of New York looks at the equity risk premium information from 20 models and estimates the ERP for various time periods. Extraordinarily it finds that the (preferred) estimator places the one-year equity premium in July 2013 at 14.5 percent, the highest level in 50 years and well above the 10.5 percent that was reached
during the financial crisis in 2009.

The models also show broad agreement that the term structure of  equity risk premia is high and flat: expected excess returns at all foreseeable horizons are just as high as  at the one-year horizon. A high equity premium that is not expected to mean-revert in the near future is an unprecedented phenomenon. Because expected dividend growth has not been above average in 2013, the paper concludes the high equity premium is mostly due to unusually low discount rates at all horizons.

 

To access the article, The Equity Risk Premium: A Consensus of Models, click here

As part of the broader trend to become professional organisations, pension funds and soverieng wealth funds are expanding geographically with the establishment of satellite offices. This expansion raises concerns of governance, culture, politics and talent.

This paper looks at the case studies from 12 funds that have launched or considering launching satellite offices and offers a set of principles that could guide investors on this path.

To access the paper click below

Getting closer to the action -why pension and sovereign funds are expanding geographically

This year the $12 billion Ohio School Employees Retirement System is prioritising projects that fulfil the board’s desire to find income from alternative sources and manage risk, including allocating more to real assets, and initiating an RFP on a risk management system. Farouki Majeed speaks to Amanda White about the fund’s investment program.

 

With a fund the size of Ohio School Employees Retirement System (SERS), director of investments Farouki Majeed is enjoying the ability to be more nimble and opportunistic in the investment approach.

Previous to this role he spent five years at CalPERS as senior investment officer of asset allocation and risk management. While clearly there are many benefits to working at a fund like CalPERS, at 20 times the portfolio size of Ohio SERS it also has limitations. A $12 billion portfolio, fully outsourced, is a different beast to tame.

Ohio SERS completed its asset liability study last year, and this year will implement the minor tweaks to the strategic asset allocation, which include reducing the hedge fund allocation from 15 to 10 per cent, and increasing real assets from 10 to 15 per cent.

“We have had a shift to tangible/income related returns because of low interest rates and our need to look for income from other sources,” Majeed says. “We are looking at not just total returns but from income and growth and other sources.”

The real assets bucket, which was previously only a real estate portfolio, also includes infrastructure and REITs, with the fund also considering timber investments.

While the hedge fund program has been reduced, the fund is still committed to using hedge funds, and sees the recent move as more of management of the program, which has grown quickly since its introduction in 2009.

Majeed says the hedge fund portfolio, which is all direct, is also morphing from a 50:50 equities and fixed income substitute, to a more diversified exposure.

“We are making it more diversified across hedge fund exposures and reducing our equity beta. This means we are looking at event driven, relative value, and global macro strategies.”

In addition to the strategic asset allocation review every three years, in the past year the fund introduced an annual review of investments and capital market expectations so it can make tweaks to exposures along the way.

“This is a new thing to be more dynamic, but it doesn’t mean it will always result in change,” Majeed says.

For example allocating to inflation-sensitive assets has been a consideration for the fund, and at the annual investment review last week, it was decided an allocation shoud remain on watch.

“We have been questionoing the role in our asset allocation of the exposure to inflation-sensitive assets. Last year we said it was not the time to allocate, because of outlook for inflation and disinflationary trends. Last week we reviewed that again and decided we would not allocation to inflation-sensitive assets,” he says. “These are the types of things we look at it in an annual review.”

The fund is also looking at the feasibility of allocating up to 5 per cent on opportunistic investments.

“We already have about a 1.5 per cent allocation to a variety of opportunistic investments, which are organised with a special purpose to take advantage of certain anomalies, such as the concept of bank deleveraging in Europe.”

Ohio SERS already has two different funds targeting European banking debt, and Majeed says the 700-odd US banks on the FIDC’s official list of problem banks are also a target.

“They are under capitalised and had to write off assets, this is an opportunity for us to act as a capital provider,” he says.

With a strategic allocation to fixed income of 19 per cent, and an actual allocation closer to 15 per cent, Ohio SERS has a lower than average allocation to the fixed income.

While opportunistic allocations and hedge funds are a fill in for fixed income, the allocation is still underweight, and overweight equities.

Within the equities allocation, US and European equities are overweight and there is a slight underweighting to emerging markets. The overall allocation to equities is 45 per cent, with a further 10 per cent in private equity, and is split roughly 50:50 US and non US.

While the overweight position in equities is quite deliberate, Majeed says it is only a single grade, and the fund is discussing with the strategy team the option of a tactical asset allocation overlay.

“Underweight fixed income and overweight equities is a single trade, when it goes wrong it can go badly, so we need more breadth with our tactical positioning. We are looking to possibly partner on an overlay, purely derivatives and based on valuation, we are interested in style premia as well.”

Ohio SERS is looking at more optimal ways to manage its allocations, and understanding its exposures in risk terms, and is in “RFP mode” for a risk platform.

“We want to more optimally manage allocations. An internal risk system gives you some additional insights and metrics into positions, understanding exposures in risk terms and allocating accordingly.”

The board, which had an offsite last week, is also finalising its investment beliefs. While the fund has not yet adopted those yet, Majeed says beliefs around active management, risk premia, long-term holdings, and sustainability are being considered.

 

 

 

The CFA Institute’s president John Rogers, believes there is evidence of innovation in investment products that meet the needs of asset owners in a more sustainable, longer-term way, and points to the work of professors and advisors to the CFA , Andrew Lo of MIT and Robert Shiller of Yale.

 

One of the main thrusts of the CFA Institute’s Future of Finance project is around retirement security – shining a light at the systemic level on what constitutes a sustainable retirement system. Connected, and separate to that, is a focus on innovation.

“We want to ensure that the global financial crisis doesn’t lead to reduced innovation, the industry still needs health innovation,” Rogers says. “This means investment products that meet the needs of asset owners in a more sustainable, longer-term way.”

Rogers points to the work of professor Andrew Lo, from MIT, who is an advisor to CFA Institute has applied the concepts of pooling risk in the insurance industry to a fund that would generate double-digit returns as well as invest in orphan drug development.

Lo’s fund idea is that it pools a large number of drug development efforts into a single financial entity or “mega-fund.” With the lower risk that comes from investing in multiple drug trials simultaneously, the fund yields a more attractive risk-adjusted return on the investment and a higher likelihood of success in finding cures for diseases. This, in turn, enables the fund to raise money by issuing “research-backed obligations” or RBOs, bonds guaranteed by the portfolio of possible drugs and their associated intellectual property. Because RBOs are structured as bonds, they appeal to fixed-income investors, who collectively represent a much larger pool of capital and who have traditionally not been able to participate in investments in early-stage drug development.

In his paper, Financing drug discovery for orphan diseases, numerical simulations suggest that an orphan disease mega-fund of only $575 million can yield double-digit expected rates of return with only 10–20 projects in the portfolio.

It’s an example that Rogers says uses innovation to generate returns for investors as well as align them with society and the economy at large, which is the missing link, and criticism of the finance industry – that it exists in a silo with little concern for, or even recognition of, the wider economy and society.

Similarly the work of Nobel Prize winner, Robert Shiller from Yale, produces “hard headed” solutions for social purpose, such as bonds, making them attractive to investors.

Rogers believes in an era of fiduciary capitalism, where asset owners and other institutional investors regain the power and direction of where, how and at what cost their assets are invested.

“It is hard work for institutional investors, much of their time is spent on investing and administering their portfolios in an efficient way. Asset owners should feel good, they’ve insourced and indexed to ground down costs. It is commendable but unfortunately not the whole job,” he says. “It is hard for large asset owners to move in and out of investments which leads to them owning all of the externalities, positive and negative, of the companies they own, because they are universal owners.”

He believes there is an opportunity, and challenge, for investors to engage more effectively with governance and individual issues, across industry sector and public policy debates.

“It is a really difficult task and it is too often left to simply hiring a high quality proxy firm, but that is not enough,” he says. “There are enormous business opportunities for fund managers willing to provide engagement with asset owners.”

 

2013 was a great year to add value by using risk to assign asset allocation, according to chief investment officer of Windham Capital, Lucas Turton, whose fund added 300 basis points above benchmark last year by dynamically allocating according to risk.

 

Windham Capital Management’s style is to focus on measuring and understanding risk to then make dynamic top down asset allocation decisions.

“We use risk in assigning asset allocation, 2013 was a good year to do that, it worked for us, we generated alpha,” says chief investment officer Lucas Turton.

Depending on risk, and the health of markets, rather than economic or bottom up analysis means the allocation of assets is often contrarian.

The fund began last year aggressively allocated despite the fiscal cliff and government shut down in the US.

“This is because markets weren’t responding to this situation, but the news had investors cautious. It was contrarian to be aggressive,” he says.

In March and April interest rates were beginning to behave and real estate was converging on bonds, which was identified as more of a regime shift, so a reduction in risk ensued.

“We are not basing our investment decisions on the Fed or geopolitical activity but when markets are susceptible,” Turton says.

About half the time last year, the Windham portfolio was contrarian, and the other half it was in line with markets.

“In the middle of year there was greater consensus markets were becoming more risky. And we reduced risk twice in the middle of the year.”

However what remained contrarian was the degree to which the portfolio reduced risk, with a 30 per cent decrease in growth assets.

“The magnitude was contrarian,” Turton says.

The fund has constraints of about 30 per cent either side of a benchmark allocation, allowing significant shifts and value to be added through better asset allocation.

The benchmark portfolio is a globally diversified passively managed mix of global equities, fixed income, commodities and real estate.

Windham, which was founded by MIT professor Mark Kritzman, uses proprietary measures to look at the global market risk environment, recognise when it changes and position portfolios to take advantage of the conditions.

“What we’ve been trying to determine is where any view matters too much to investors. We don’t think valuations such as P:E ratios impact returns, something that looks inexpensive can become cheaper. We want to look at risk.”

So far this year Turton believes there has been a modest uptick in measures of risk, but that generally markets are calm.

“It has risen this year and is approaching the level of April last year but it’s nowhere near 2011. We have seen a sell-off in an orderly fashion where correlations were low, it’s a traditional pull back after very strong market,” he says.

The outlook in the near term is that risk is low, so Windham is allocating to a diverse set of risky assets, with commodities and US REITs both big diversifiers in the portfolio, and allocations to foreign assets increasing.

“Clients are concerned with alpha and downside protection. We believe short term returns are difficult to predict but risk is somewhat predicable and can add value,” Turton says. “We are correctly anticipating the direction of risk.”