Danish pension provider Danica is upping the alternatives portion in its roughly $57-billion portfolio as it looks to boost returns within the country’s strict solvency framework. Alternatives already make up over 4 per cent of the $33-billion Traditional Fund, Danica’s largest and most conventional pension pool, double the proportion the asset class took at the end of 2010.

Peter Lindegaard, Danica chief investment officer, says that infrastructure is at the heart of a drive to treble its alternatives holdings again to a total 20 billion Danish krone ($3.6 billion). “We already have a number of investments in infrastructure funds and it is something we want to continue with as well as going a bit more directly,” he says.

The direct investments in the asset class have naturally followed from committing to infrastructure funds. “Some of these funds have co-investment opportunities for project equity investment”, Lindegaard says.

While the number of opportunities is limited in small and infrastructurally efficient Denmark, Lindegaard is enthusiastic about potential overseas investments. Danica is approaching infrastructure with a broad scope, according to Lindegaard, and will consider any form of the asset “as long as it’s not too exotic”.

Hedge funds, timber, agriculture, private equity and alternative credit are the other possible components of Danica’s alternatives effort. The alternatives it holds already returned a healthy 10.2 per cent in 2012, clearly a figure that would satisfy the fund in the future.

In another indication of how mainstream the asset class is becoming to Danica’s plans, Lindegaard isn’t too happy with alternatives’ name. “Maybe we should start calling them illiquid investments,” he says.

Limited wiggle room

Like many investors, Danica’s alternatives drive has a clear objective in reducing a dependence on bonds. “Everybody wants to sell government bonds and invest in everything else”, is Lindegaard’s rather frank way of expressing it.

Danica shed $2.3 billion from the bond holdings of its Traditional Fund in the course of 2012, although its conventional debt holdings still occupy 60 per cent of the portfolio.

Lindegaard frequently refers to the fund’s risk budget and buffers. A need to focus on risk stems from the fact that Danish pension-solvency regulations, which came into force in 2002, place strict limits on the amount of “high-risk” assets the country’s pension funds can hold.

Equities occupy a mere 5 per cent of the Traditional Fund’s portfolio, perhaps meaning that Danica has somewhat missed out on the current equity boom, but also ensuring it misses out on the volatility of the asset class.

“As interest rates are so low, we have had to hold onto a lot of bonds and we don’t have a risk budget that allows us take much equity exposure,” Lindegaard explains.

As the Danish solvency regulations are akin to the European Commission’s proposed Solvency II-style limits on pension funds, the decisions Danica has taken in recent years will possibly need to be echoed across the continent in the future.

Lindegaard hopes the controversial forthcoming European regulations are shaped in a way that allows “conscious controlled risk taking”.

Danica has found space within the Danish regulations to take some bolder positions within its debt holdings.

For instance, Danica has largely held intact a significant position it had at the start of 2011 of 2.8 per cent of its customer funds in Irish, Italian and Spanish government bonds. “We are constantly looking for the best risk-reward options, and from this point of view these bonds looked good and still look pretty good,” Lindegaard says.

Outside of its liability-matching bond portfolio, the Danica Traditional Fund also has $5.5 billion in higher yielding “credit investments”. These assets delivered 14.4 per cent returns in 2012.

That is not unusual for Danish pension funds’ credit bonds holdings, Lindegaard says, as “interest rates fell at the same time as the spreads came in”.

Sturdy foundations

Danica also takes a strong position in real estate. Most of its $3.49 billion real estate portfolio is directly owned in Denmark. The fund ranks as one of the country’s most significant owners across the residential, commercial and retail spaces. Lindegaard says Danica plans to increase its real estate holdings further, both in Denmark and by “dipping its toe” in overseas real estate via funds.

He says “there are issues in the Danish property market right now like anywhere else but we can make very interesting new investments as there is a lack of capital out there. If you are the ones that can deploy it you can get relatively good interest rates out of it.”

Some 78 per cent of assets at Danica are managed by Danske Capital, which shares the same parent company to the pension provider in Danske Bank. Another 9 per cent is managed by BlackRock.

Lindegaard reveals that Danica is very neutral on the passive versus active management debate. “We have a mix. In some asset classes it is difficult to beat the benchmark but in others, like emerging markets, you can make a very nice return with some active management,” he says.

 

If Tony Broccardo, head of Oak Pensions Asset Management, the investment arm of the £23-billion ($35.6-billion) pension fund for employees of London-headquartered bank, Barclays, wasn’t a fund manager he would have been an architect. But Broccardo has applied similar skills of stress testing, planning and making something structurally secure to the return-seeking fund, one of the United Kingdom’s largest and most sophisticated schemes. It posted a per annum return of 11 per cent for the three years to December 2012 and Broccardo, who started out as an investment analyst and strategist at brokerage houses before joining the scheme as its inaugural chief investment officer in 2008 from F&C Investments, attributes success in today’s difficult climate to a strategy combining active management, diversification and flexibility. “We have proved the concept of greater diversification and active management,” he enthuses. “Over the last three years, which includes the crisis period, we added $1.08 billion to the fund. Over five years we have added $2.3 billion over and above what we’d have made with an equivalent passive bond and equity portfolio.”

In the belly of OPAM

The fund, which manages assets for around 250,000 current and former Barclays employees, was restructured in 2010 when the bank set up its own asset manager, Oak Pensions Asset Management (OPAM). Like other big UK schemes such as the Universities Superannuation Scheme, the closed coal-industry pension schemes and retail giant Tesco, Barclays took back control of strategy from external advisors in a decision Broccardo says allowed both flexibility and “real-time investment management solutions”. The OPAM team is split three ways comprising manager selection – trustees handled all fund-manager oversight before OPAM – an implementation team and an asset allocation team. Most members of the 14-stong internal team have hedge fund backgrounds and, excluding private equity, the fund uses 40-odd managers. Managers responsible for at least 5 per cent of the total assets under management include BlackRock, Aberdeen Property Investors, Russell Investment Group and Towers Watson. The use of an overlay allows “huge flexibility” in selecting the best active managers and Project Smart, an internal initiative applied to all active mandates, measures strategies using smart benchmarks and indices to see how managers are doing. “We apply SMART to all allocations. It is very much the case that the trustees want Oak to focus on strategy; they allow us to use more or less managers as the opportunities arise.”
Within its 20-per-cent equity allocation, OPAM has steadily increased its risk levels, pushing active management of mandates and “much higher exposure” to emerging markets – three times more than what it was in 2010. Broccardo has also introduced tilts to its equity portfolio, shifting allocations to take advantage of specific pockets of outperformance. “Last year we increased our exposure to Europe out of US equities. We’ve also increased our exposure to global companies and the tilts in place here have done very well,” he says, adding that OPAM will continue with a strategy to gradually pare down its equity allocation in favour of alternatives.

Diversification pays

The fund currently has a 12-per-cent allocation to private markets comprising property, infrastructure and private equity. Private equity investment is global and includes stakes in technology, clean energy and medical start-ups. “Diversification has paid off; we’ve gained an illiquidity premium investing in private equity over public markets,” he says. Infrastructure investment lies across “different industries” but the fund has only recently made its first foray into the UK in a strategy to tap both growth and hedge against inflation risk. It’s a trend increasingly evident among other UK schemes, pouncing on domestic infrastructure assets as banks pull back from the sector because of new capital rules. In its second private placement to a UK water company, the Universities Superannaution Scheme has just structured a $147-million loan for London water authority, Affinity. “We’re looking to benefit from increases in the value of the underlying investment, but also get exposure to UK inflation and rate rises. Our liabilities are in the UK so we do have a preference for UK infrastructure,” says Broccardo.
OPAM allocates 35 per cent of its portfolio to liability-driven investments and 20 per cent to credit. Here the approach is “wholly proactive” fashioned to both lock down liabilities but be flexible and creative too. The focus, explains Broccardo, is on rebalancing the mix of exposures and replacing one strategy with another – tilts are applied here too. For example, in a bid to tap medium-term returns further down the credit spectrum the allocation is titled to high yielding assets in the credit market like issuers in countries such as Spain or Italy. It’s a risk appetite apparent again in the 12 per cent allocation to diversified assets. Global tactical asset allocation mandates to exploit short-term market anomalies, macro strategies seeking profit from economic uncertainty and commodity and niche currency exposure all come under this umbrella. “The majority of these strategies are implemented by hedge funds, specifically focusing on strategies less correlated with equity or credit risk,” says Broccardo.

One fund, one strategy

Looking ahead, OPAM will continue to “modestly increase risk.” Positively, Broccardo believes there is less tail risk thanks to recent policy action in the US, although “adverse outcomes could still have an impact on markets”. A fall in corporate profit margins may still negatively affect equity portfolios and rising interest rates impacting long-dated debt is the other concern. “History suggests that if the market is concerned about inflation, the sell-off will be abrupt.” He says OPAM’s focus is on spare capacity within larger economies with so-called output gaps. The idea to “assess where there is still headroom for growth before inflation expectations kick in,” he says.
OPAM’s success begs the question – will they run money for other pension schemes? It’s a model developed by Hermes, set up as inhouse manager for telecoms operator BT’s pension scheme but now with mandates from other pension schemes too. But Broccardo won’t be drawn: “We just think about how to improve the outcome of one fund and one strategy,” he says. No, his eye is firmly on how big the Barclays fund, up from $27.8 billion in 2007, could one day become. “We can look back over a number of years and see how we have moved the dial. We are now big enough to move the dial.”

While the responsible investment field has come a long way, the majority of investors are still treating it as an overlay, rather than truly integrating it into investment decision-making.

This is not an ideal situation for the investment industry, not to mention society at large, but it presents an opportunity for those that do integrate enviroment, social and governance (ESG) issues with investments, and do it well.

For the past three years the giant Dutch pension manager, PGGM, has had a specific portfolio, the The essence of the portfolio is a long-term investment horizon that integrates financial and ESG factors with active ownership. The Responsible Equity Portfolio is worth about 3 per cent of the overall assets of €125 billion ($167 billion).

Responsible investment 2.0

Now the head of that strategy, Alex van der Velden, and a number of the team have started a new independent firm that offers strategies managed in the same vein.

It’s the “next generation” of responsible investment evolution.

“From an investment perspective you do ESG analysis to prevent the problems. When we showed up to invest, conditional on improvement of the issues, it was win/win. The effect is greater the larger the bag of money you can put on the table,” van der Velden, who is chief investment officer of the new venture, says.

He says in the past few years there have been perceived positive moves in the market regarding ESG awareness, but in reality little uptake.

“People accept principles of responsible investment and there is more open-mindedness to the concept. But it is also a façade that people can hide behind and do nothing. Most funds managers are hardly doing anything. If you ask at the portfolio-manager level, it is not happening at that level,” he told top1000funds.com in July last year.

It is a challenge that most investment processes don’t deal with qualitative processes like ESG or are involved in investee companies.

This next generation of responsible investing that van der Velden and his team are adopting at Ownership Capital integrates ESG considerations as part of the fundamental investment framework.

As at PGGM, the strategic objectives of the portfolio are ESG integration and active ownership, with the point of integration to see how ESG could add value to – or detract value from – a company. This is implemented through better stock selection of sustainability leaders and through better management of ESG risk by catalysing ESG improvements at laggards through active ownership.

There is a three-pronged analytical approach involving fundamental financial analysis, ESG integration and active ownership. There is also recognition that ESG analysis takes a substantial amount of time, not just to understand the specific facts but, more importantly, to understand their financial relevance, and the approach is active and concentrated.

Canary in the coalmine

Van der Velden says that many funds have adopted engagement with companies but that strategy falls short in fulfilling the original ambition.

“The investment decision has already been made,” he says. “It’s reactive engagement on policy issues not doing research and engagement before the investment. PGGM realised that to generate investment value from ESG, analysis need to be part of the investment process. The philosophy worked well: when we added ESG analysis or engaged with a company, we made better decisions.”

The process also revealed further problems within the company.

“A measure of success is returns but also the investment decisions you didn’t make, we noticed ESG problems were a canary in the coalmine for deeper issues the companies had.”

Van der Velden believes this process is not more pervasive in the investment industry for a number of reasons. “There is a cultural aversion to considering qualitative factors – the investment industry is quant-based and incentive structures are short term in nature,” he says. “Also, ESG is not a short-term value driver: if you only have a 12-month horizon, you won’t do ESG analysis.”

One unified strategy

The new firm has an eight-man investment team headed by Sir George Buckley, the former chief executive officer of 3M, the US manufacturing and innovation company, and van der Velden. They met when van der Velden’s team were engaged investors in 3M.

The long-time horizon fund will invest in a concentrated portfolio of North American and European equities for international institutional investors, with a target fund size of $2.67 billon. The portfolio combines fundamental financial analysis, ESG analysis and active ownership into one unified strategy with the overarching aim of identifying companies that are financially attractive, responsible and open to engagement.

In practice this means the investment process involves financial analysis and modelling, ESG analysis and measurement, in an active dialogue with investee companies from the start.

He says in many investment organisations ESG continues to be dismissed as financially irrelevant, but he believes a culture of open-mindedness must be nurtured in which both ESG and financial factors can be seen as critical and as correlated over the longer term.

Buckley, who is chairman of Ownership Capital, says the turbulent economc environment calls for shareholder engagement and a sustainable approach to business.

“The chance to chase a quick dollar (and the fear of not doing so) has distracted investors in the past, often to the detriment of long-term growth and good returns, and this simply has to change if we’re to get the economy back on track. It’s not about the next quarter or even the next year – it’s about the next decade,” he says.

“A narrow focus on buying and selling has made owning with skill something of a forgotten art,” said van der Velden says. “Our experience has shown that ‘ownership investing’ not only contributes to better corporate governance and sustainability, it ultimately generates higher investment returns.”

 

For a profile of PGGM’s approach, click here.

I’ve been contemplating the “smart beta” wave the industry seems to be riding at the moment. Cynically, part of that contemplation asks whether there is any innovation at play or whether it’s simply the industry playing with nomenclature once again.

The answer is confusing, for while I’d like to be able to write it off as some sort of marketing game, there seems to be some real benefit to the end-investor of this smart beta trend.

Whenever a journalist contemplates something, it means a lot of research and part of the way I research is by talking to people. On this issue I’ve sought the insight of many people close to the trend – academics, investors and service providers.

Of those service providers whose opinion I value, State Street and AQR rate up there.

It’s not my usual practice to name service providers, in fact I don’t really even like writing about them, but the reason I rate them, and this is not exclusive, is they have a direct link with academia, applying the latest thinking to practice. And this is true of the thinking around smart beta.

If flows are anything to go by then this so-called wave is real.

The S&P Low Volatility ETF had flows of $2.5 billion in 12 months and now has the most assets under management of any ETF.

Similarly, the trend is demonstrated in State Street Global Advisors’ flows, while the bulk of it’s $1 trillion in global passive equity remains in traditional core cap-weighted indices, last year 40 per cent of its institutional inflows in this part of the business were into smart beta.

Smart beta defined

The definition of smart beta can be broad. Lynn Blake, global chief investment officer of SSGA’s global passive equities business, says it is an “objective, consistent, transparent measure of achieving some investment exposure”. In academia, smart beta really started about 10 years ago with fundamental indexing, ballooning as a topic of research, and now weighting portfolios by risk characteristics, such as volatility, has become the mode du jour.

It can be distilled into the fact that empirical evidence shows that there are certain factors that drive returns. These include price to valuation, low volatility, size and momentum.

Smart beta is implementing that thinking, so a portfolio is tilted towards one or, in the case of AQR’s products, many of these factors. AQR identifies four styles of premia – value, momentum, carry and defensive – and combines them in seven different places including industries, countries and currencies.

The benefit to investors is that the veil is being drawn back on what were often previously thought of as active strategies, so now investors can see whether there is really manager skill involved and whether it’s worth paying for.

Many active managers figured out years ago that value and momentum were drivers of return. Investors were paying active fees for that knowledge, and a tilt towards a style premia, but what smart beta now demonstrates is that knowledge is not necessarily skill.

The development of academic thinking and tools, and the application of it, is providing clarity around alpha, or the lack of it, and hopefully more transparent and fairly priced offerings.

The age of style tilts

While I think I’m convinced that alpha does exist, I know that tilting towards, say, value, is not it. So investors shouldn’t pay an active fee for that.

I must add, however, while I see an eventually bright future in product development and appropriate pricing, I also see a plethora of products about to explode onto the market, which investors will have to wade through to get to any eventual Mecca.

Apparently there are now already as many indexes as there are stocks, and we haven’t even really started on style-tilted indexes, not to mention combinations of style tilts.

As this new wave of industry development continues, investors have a chance to make some demands. Expect innovation, expect transparency, expect to pay appropriately, and expect honesty. If you don’t get it, don’t do business with those organisations. It’s simple really.

Things are suddenly looking cheerful again in the world of Dutch pensions.

The country’s famous tulip fields might not be set to bloom until April, but investors already have a harvest to delight at from a good year of investing.

For instance, Hans de Ruiter, chief investment officer of the €2.5-billion ($3.36-billion) TNO pension fund in the Netherlands, can look back on a 14.8-per-cent investment return in 2012.

It is a real sign of how positive 2012 was as an investing year that de Ruiter can label such returns as “unexceptional”. The TNO fund only just beat its benchmark after all, and de Ruiter can point to many other Dutch funds with similar or superior returns. De Ruiter says that younger pension funds in the Netherlands that follow liability-matching strategies similar to TNO’s boast even stronger 2012 results. The TNO fund, formed in 1939 by the TNO scientific research institute, has a medium average-liability duration of 15 to 16 years.

The investment returns are a definite relief in any case to the funding position of TNO’s pension fund. The fund has emerged from a deficit to post a 4.8-per-cent surplus at the end of 2012.

This surplus beats the TNO fund’s minimum requirements and therefore reduces the threat of the fund imposing benefit cuts on its 15,000 members.

It is not just a tale of miracle returns restoring the fund to health, however.

While supported by the investment gains, the 5.1-percentage-point overall boost to the TNO fund’s funding position in 2012 was largely carried by the introduction of the new ultimate forward rate in September as part of the Dutch pension reforms.

Fixed income switching

De Ruiter says that the TNO fund will be keeping its diversified, liability-matching asset mix broadly identical in the year ahead as it aims to build on recent gains. Among its alternative holdings, the fund has over 10 per cent of its assets in private equity, over 5 per cent in property and close to 3 per cent in interest-rate and currency hedges.

The most significant recent changes have been within the bond portfolio. These have seen the fixed income holdings increased from under 50 per cent to 56 per cent of assets.

Intriguingly, government bond holdings have been increased as part of the TNO fund’s fixed income drive. At 18 per cent of the fund, government holdings still have less than half the combined presence of corporate, high yield and emerging market debt, however.

De Ruiter explained that the recent bond purchases have been inspired by a reduction in the fund’s swap overlay. Interest rate risk is now just 55 per cent hedged at the fund, a reduction of some 10 percentage points. “We want to be less dependent on swap overlays and do more liability matching through physical positions” de Ruiter says. A desire to reduce leverage and counterparty risk on the balance sheet were cited by de Ruiter as reasons for this move.

De Ruiter admits he is concerned at the low yields offered by the German, Dutch and French government bonds that make up the majority of the TNO fund’s holding of state issues. However, with European corporate debt holdings also being beefed up, he is confident that the overall asset mix better matches liabilities with this move.

Cool on bricks and hedges

Real estate and hedge funds are asset classes that have stepped aside to make space for TNO’s bolstered bond position. De Ruiter explains that the fund has underweighted real estate to 5.5 per cent of the portfolio – half its 2010 position – following a disastrous minus 16.6 per cent performance in 2011. A one-off hit from since disposed-office structured-debt investments contributed to those poor returns. The asset class is proving to be “still disappointing” for the fund, however, with minus 6.6 per cent returns from real estate being the single blemish on the 2012 performance figures.

A globally diversified real estate portfolio has not been able to help things of late. “There are clearly a lot of issues such as overcapacity in various countries which have kept us from investing in recent years,” de Ruiter says. While he feels there will be a “difficult environment” for real estate in the next few years, he remains confident in the asset class’s long-term potential.

De Ruiter is, however, less keen on hedge funds, labeling the asset class “too expensive and lacking transparency”. TNO’s hedge fund portfolio performed worse than its equities in 2011, losing 7.2 per cent of value. De Ruiter explains that since then, the TNO fund has divested from a fund-of-funds position and is in the process of incorporating the rump of its hedge fund investments into its private equity portfolio. The TNO fund, though, will retain the option of investing in hedge funds on an opportunistic basis when it can identify good managers.

Private equity for its part has been overperforming of late, with 8.3 per cent returns in 2012 following two years of double-digit returns. The fund has decided not to make new private equity investments until the end of 2013, while allowing existing mandates to expire, in order to bring the asset class down to the 7-per-cent holding that it has strategically targeted.

Sitting tight with passive equities

The 16-per-cent return on the TNO fund’s $668-million-plus equity holdings was the strongest of all in 2012.

TNO has benefited from a wide geographic spread, with 39 per cent of equities invested in US firms and 24 per cent in emerging markets at the end of 2011.

The equity portfolio has been managed completely passively since the start of 2012. “There were no strong indications of the added value of asset management over a long time horizon, so we came to the simple conclusion it might be better to invest passively, as cheap as possible” says de Ruiter.

Defined-benefit funds all over the world are focused on de-risking but the amount of innovation and players to meet this demand is wanting. Until now.

A new report by the Pensions Institute at the Cass Business School examines the emergence of medically enhanced, underwritten or enhanced, bulk buy-ins, in which trustees buy a bulk annuity as an investment of the scheme, where some or all of the members covered by the policy are medically underwritten.

The argument is that medically underwritten annuities can bring cost savings to a de-risking approach that offers an effective hedge against a range of risks including interest rate, inflation, investment and longevity risks. Read the full report below.

HealthierWayToDeRisk