Peter Wallach, head of the United Kingdom’s Merseyside Pension Fund isn’t overly worried about the recent fall in equities.

“Markets are being driven by liquidity from central banks; this is more about central banks just needing to reassure investors,” he says.

“It is bonds, to our mind, that are over-valued in the medium to long term.”

There is another reason why Wallach, speaking from the local authority fund’s Liverpool headquarters on the banks of the Mersey, can afford to play down recent jitters in global equities. Despite the £5.75 billion open, defined-benefit local authority scheme still being very much in growth mode, a strategy to iron out volatility has afforded Merseyside an extra cushion from market bouts like today’s.

The fund has a 55 per cent equity allocation; a 10 per cent real estate allocation invested in the UK and international and specialist property funds; 14 per cent in alternatives; and 1 per cent in cash. The balance is in fixed income, namely government and corporate bonds. It’s an asset mix shaped by a gradual paring down of the fund’s equity exposure and boosting of its alternatives in a strategy designed to end the volatility attached to the large equity portfolios typical of many local authority schemes where the average equity allocation is 63 per cent.

Alternative view

In 2007 Merseyside’s only alternative allocations were to private equity and hedge funds. Now its alternative holdings encompass private equity (4 per cent) hedge funds (5 per cent) infrastructure (2 per cent) and an opportunities fund (3 per cent). A seven-strong team manages the entire alternative portfolio in. In contrast the full bond and the majority of the equity mandates are run externally.

“Excluding private equity our alternatives are less correlated; there was also a feeling that bonds wouldn’t give us the returns we needed and that core infrastructure was more likely to,” says Wallach, who ran portfolios for high-net-worth individuals (HNWIs) as a private sector wealth manager before joining Merseyside.

“I suppose you could say I’ve bought a more commercial outlook.”

Within the alternatives allocation, private equity is doing best. In a strategy honed over the past 20 years, Merseyside uses advisors but identifies, implements and monitors all private equity plays in-house, holding a diverse portfolio split by geography, vintage and fund type, although Wallach notes the geographical diversity is increasingly less significant as funds become more global.

“Apart from small European or US buy-out funds, a geographical weighting is hard now because large buy-out funds aren’t limited by geography,” he says.

The shift away from regional plays hasn’t impacted returns, averaging 14 per cent a year for the last two decades.

“We are very pleased with private equity,” he says.

The infrastructure allocation is similarly global. The core allocation is in private finance initiative (PFI) funds, some backed over ten years ago, but the scheme also invests in Asia Pacific infrastructure funds that are higher risk or “development-type” funds; and in renewable energy infrastructure designed to benefit from European subsidies to the sector.

Although Wallach hasn’t ruled out investing in the government’s Pension Infrastructure Platform (PIP), Merseyside isn’t a founder investor because of the start-up nature of the fund.

“In principle the PIP makes a lot of sense and we will continue to evaluate it as it comes on stream but we wanted to get money to work more quickly and the PIP is still in its genesis,” Wallach says.

A long look at hedge funds

It is hedge funds that have been the trickiest alternative. Although the allocation has modestly outperformed HRRX hedge fund indices, lacklustre returns and a changed market prompted the scheme to take a “long look” at its hedge fund allocations six months ago, testing their case for remaining in the portfolio.

“Absolute returns in the hedge fund allocation have only been satisfactory and not as high as we would have liked over the past five years,” Wallach says.

He who attributes part of the problem to the strong equity market.

“Hedge funds need more differentiation at the stock level and dispersion of returns has been low for a long time,” he says.

“However I do think the market is starting to move back in favour of equity long short and arbitrage funds as dispersion increases.”

In another strategy to reduce volatility, Merseyside has invested in smart beta. About five years ago, around the same time it pushed its allocation to alternatives, the fund allocated 3 per cent of its equity portfolio to an actively managed European minimum variance portfolio with Swiss asset manager Unigestion.

“We think there is a lot to be said for smart beta,” enthuses Wallach.

“The idea that the greater risk leads to the greater return has been challenged by the persistent outperformance of low volatility stocks.”

Since inception, returns have been 81.1 per cent, beating the benchmark, and with a volatility of 16 per cent against the benchmark’s 21.5 per cent. Given the European benchmark has risen 66.6 per cent over the equivalent period, Wallach is quick to credit what he calls an element of luck in the timing of the investment – but he says it’s a strategy that is likely to grow at the fund nonetheless.

“It’s not a silver bullet; we’d always hold it alongside other equity strategies,” he says.

Within that broader equity allocation, all US mandates are passive.

“The US is the most efficient market; it’s very difficult to outperform here,” Wallach says.

The UK is a mixture of active and passive while Japan and emerging market equity allocations are wholly active. Merseyside also allocates its equity portfolio regionally, rather than globally in a targeted approach because “the world is an enormous benchmark”.

Tapping into growth

It is a strategy also designed to tap growth in fast-growing mid-cap stocks. Although global managers get to invest in the best companies in the world, this way Merseyside can invest in companies further down the market capitalization scale, Wallach explains.

“By default we end up looking at a larger number of stocks,” he says.

Although Wallach notes Merseyside’s gradual shift in maturity it has not had an impact on investment strategy yet.

“We have matured much more quickly in the last six years but it is not a significant worry,” he says.

“We are putting things in place to manage our maturity.”

Early signs include a shift from cash positive to cash negative in terms of payments, although Wallach says the fund has a buffer in substantial investment income. The scheme is looking at ways to hedge its liabilities more effectively but will only put such strategies in place when it’s “appropriate.” It already offers a few of its employers tailored liability matching strategies.

“There is a lot more scaremongering about the effects of maturity than is warranted,” he says.

One of the UK’s largest local authority schemes, and the first amongst its peers to adopt innovative strategies, when the time comes Merseyside is sure to lead here too.

 

A solvency ratio of 157 per cent is a clear mark of success for a pension fund at a time when so many are battling deficits. Remarkably, Sweden’s SEK90-billion ($14 billion) KPA Pension has gained this funding cushion without fully embracing the range of new asset classes or strategies often touted as the solution to funds’ problems.

KPA’s asset mix has a distinctly traditional look – 95 per cent is in bonds and equities – but much of its success can be attributed to picking the right extra investment devices at the right time.

Chief investment officer of KPA Michael Kjeller explains that gaining “very strong” interest rate protection via swaps in the build up to the financial crisis allowed the fund to thrive in 2008 and 2009 when others had their fingers burnt – the fund returned 6.3 per cent in 2008 and 11.9 per cent in 2009. A decade ago KPA could only count on a slight surplus so Kjeller is in no doubt of the “tremendous change” that this policy helped deliver.

A cautious approach after taking out the interest rate protection in 2005 helped KPA as it held the swaps through a couple of years of suffering. “You never know when the fire will start so we wanted to keep our insurance with interest rate swaps,” says Kjeller. When the flames of the financial crisis were subsequently lit, KPA then found its protection was in huge demand – it was therefore able to sell the interest rate swaps to others at much higher prices.

“Whether through luck or skill we did the right thing when there was most turbulence, and were then able to build on that position,” Kjeller says. With its solvency boosted, KPA started to delve into equity markets in March 2009. “From what we know today,” Kjeller chuckles, “early 2009 was a good starting point in investing in equities.” Stockholm’s OMX 30 index has doubled since then.

 Overlaying a solid foundation?

The current focal point for KPA is its use of overlays. Indeed, it is the main job at its central Stockholm headquarters as equities and fixed income assets are all managed externally. “We try to tailor the risk profile in equities, fixed income and foreign currency with futures and options,” Kjeller explains. Constructing overlays is not the easiest investment job, but KPA can count on plenty of experience in running the strategies and Kjeller is delighted with the results. “Overlays have helped us handle both positive and negative tail events rather efficiently,” he says.

The fund’s current asset mix sees fixed income take a 60-per-cent share, equities 35 per cent and the remaining 5 per cent is invested in a real estate-dominant alternative segment. Kjeller baulks at suggestions that this is a conservative approach, with the risk premium from equities having carried performance in the recent past. As stock indices have climbed, Kjeller says KPA is now more neutral on the asset class though. Approximately half of its equities are Swedish, with a “small chunk” of emerging market exposure in the international equity portfolio. As it focuses its internal efforts on overlay activities, Kjeller tries to “keep things simple” by gaining purely large-cap exposure in domestic equities.

Fixed income has played its part in KPA’s current health, with its relatively long-duration investments helping the fund to a decent 5.6-per-cent return in 2011. It is proving a little problematic these days: “Like any other pension fund the low yield on high-quality bonds is an issue for us,” Kjeller admits.

KPA invests predominantly in Swedish government bonds and covered bonds – 10-year Swedish government bonds have yields below the 2-per-cent mark. The fund has been unable to do much about the situation, Kjeller confesses. “We don’t want to take on new risk that we don’t fully understand.” This conservative view has led KPA to steer clear of high yield or senior debt investments as possible solutions.

Not so alternative

Conservatism, the desire for simplicity and the presence of the overlay strategy have all kept KPA away from embracing alternatives. “Overlays allow us to benefit from the market conditions in which alternative investments thrive, so our demand for them has decreased,” Kjeller explains.

The age of the fund has also played a part in the fund’s slow adoption of alternatives, says Kjeller. He says real estate was too much of a risk for the younger, smaller KPA – the fund was less than 5 per cent of its current size at the time it became the default fund for Swedish local authority workers in 2001. “In a mature pension fund, we feel real estate should account for between 5 to 10 per cent of assets”, says Kjeller, thereby indicating that its real estate holdings should grow further. KPA mainly invests directly in real estate, as it prefers the risk-return profile of that approach, he adds. A 1-per-cent exposure to private equity and renewable energy in its small existing alternative portfolio is “doing fine”, Kjeller states.

Having followed a sustainable policy since 1998, KPA has a strong record in sustainable investing. It blacklists alcohol companies in addition to arms, tobacco and gambling firms. Its activities in the sustainable space have incorporated Sweden’s tradition in gender equality, with KPA campaigning in support of a United Nations project that supports young women and opposes child marriage. Added to its strong solvency and investment record, it is clearly setting an ideal for other funds to emulate in many ways.

The London Business School’s emeritus professor of finance Paul Marsh admits that you have to be slightly mad to embark on the kind of research detailed in the latest edition of Global Investment Returns Yearbook. This year Marsh and colleagues Elroy Dimson and Mike Staunton – Marsh describes the three of them, pictured below, as “old men with an interest in financial history” – have pulled together over a century’s worth of historical data spanning 25 countries to forecast what investors can expect in the future from delving into the past. It’s a historical  perspective tracing returns in stocks, bonds, inflation and currencies that doesn’t bode particularly well for institutional investors in the coming 30-odd years. “The high equity returns of the second half of the twentieth century were not normal, neither were the high bond returns of the last 30 years, nor was the high real interest rate since 1980. While these periods may have conditioned our expectations, they were exceptional,” says Marsh.

Exuberance is over

Since the 1950s investors have enjoyed “pretty good” returns on bonds and high real equity returns of around 6 to 7 per cent. Since 1980, equities have done well apart from disappointment in Japan, but real bond returns have been “incredibly high” at close to 6 per cent. “World bonds actually beat world equities,” says Marsh. “Investors would have done marginally better in bonds over a period equities have also done very well. Even cash has been wonderful.”

But from a historical perspective, the high bond returns since 1980 were more a blip than anything normal. “Real returns will revert to 1 per cent, not the 3 per cent we have gotten used to over last 30 years of bonds,” Marsh forecasts. He puts real returns for long-term index-linked bonds at zero or marginally negative. Reflective of their riskier qualities, long-term conventional bondholders can expect a marginally positive return. The prospect for cash is marginally negative. “Don’t think of 2 to 3 per cent real interest rates on cash as something we are going to get back too.” Marsh, Dimson, Staunton

Similarly, equities offer little relief. “Equities won’t bail you out,” he warns. Colour-coded lines on Marsh et al’s historical charts indicate that low interest rates imply low prospective returns on all assets, including equities. “When real interest rates are low, real equity returns can also be expected to be low,” he says. “We have shown that there is a strong association between low real interest rates and low subsequent equity returns, and high real interest rates and high equity returns.” The trio estimate that the prospective real return on world equities has fallen to 3 to 3½ per cent per annum in the long term, disputing those asset managers promising 7-per-cent returns or higher still, as in the US where Marsh says forecasts are “plain crazy”. He isn’t swayed by the fantastic returns investors have enjoyed in equities in recent months or talk of a great rotation. “It doesn’t pull the rug from under us,” he says. “There is zero relationship between the first few months of a year and the rest of the year. Our prediction is that the rest of 2013, and the next generation, will find it tougher in terms of returns.”

Historical data shows that volatility damps down surprisingly quickly after shocks like the 1987 crash when stock markets around the world plummeted, or the recent financial crisis. “The world will not stop shocking us but the remarkable thing about volatility is that it reverts to its long-run average quickly after a shock.” He suggests that for “serious long-term investors” with horizons beyond 10 years strategies to manage volatility may not be worth the cost. Only for funds with a particular need for cash at distinct points in the future would strategies to manage volatility actually pay off.

Learning to live after the golden age of returns

Marsh qualifies their findings: “The projections we have made for asset returns over the next 20 to 30 years are simply our own best estimates. They will almost certainly be wrong, but we cannot predict in which direction. There will also be large year-to-year variations in return and they should be viewed strictly as long-run forecasts.” They aren’t compatible with short-term optimism or pessimism about particular asset classes, he says. However, as long-term forecasts for the next 20 to 30 years, he is convinced their estimates are realistic.

His advice to investors in a low-return world is diversity. He doesn’t recommend any smoothing of assets and says pension schemes should put away a lot more now than they did in the old days. He also warns funds to be wary of consultants peddling strategies that are more likely to increase costs rather than returns. Funds seeking yield are also said to be on the wrong track. High yielding equities or risky corporate bonds take investors into higher risk areas. “High returns need higher risk strategies, but these don’t guarantee higher returns,” he says. His message to investors is to “live with it”.

Part of the challenge is the fact institutional investors have grown used to a golden age of returns. But Marsh says the returns are still there to be had. “If we are right and investors get an equity risk premium of 3.5 per cent over the next 20 years, they will still double their money over any cash returns.” All figures are also in real terms, so add inflation and returns on equities look bigger. “Other academic figures agree with us. We might be gloomy in our predictions, but we are not alone.”

Pension funds or any investor holding a slug of long-term fixed income needs to factor in some capital losses soon, says Princeton academic and former vice president of the Federal Reserve, Alan Blinder.

“The timing is difficult to predict, but three or 15 months, it doesn’t matter. It is predictable,” he says. “The unpredictable part is the risk spreads. When interest rates increase what happens to spreads between US treasuries and AA bonds, or US and Brazilian bonds, you name it, it is not very predictable.”

What is obvious is there will be a pure capital loss on holding duration.

Blinder says interest rates have to go up but the timing of when that will start is uncertain.

“There is zero uncertainty around the fact that interest rates will go up substantially. That’s important because if you were running a pension fund, usually you can’t say that with certainty. The timing of when it starts and how fast they will rise is uncertain,” he says. “But they will start sooner and go up faster than central banks want it to go. Markets will get hyper-excited and overreact. There is no doubt Ben Bernanke would like to see a gradual normalisation. My worry is the markets’ reaction.”

More worried than confident

Blinder says it is a “close call” whether to invest in credit, but he probably wouldn’t. And part of the game changer is that central banks are now working on the long end.

“It used to be a simple story,” he says. “If the economic climate is getting better, then you wouldn’t expect risk spreads to widen, but if because central banks are generating it, then spreads would widen.”

In the US he says he is less confident about the economic outlook than market opinion.

“The market swings too whimsically in both directions. It is too euphoric about fickle indicators like confidence,” he says. “I’m more worried than confident about the US economy in the next two years. In the long term I’m confident about the US’ ability to supply goods, but in the short term we need buyers.”

More generally, he is bemused by the actions of governments and the way they are acting as dampeners of demand.

“It is unprecedented to see governments contracting in period of economic weakness. Greece can blame the IMF, but the US can’t, the government should be spending.”

A paradox of public opinion

Blinder says there is a paradox of public opinion with regard to fiscal rectitude.

“The voters love it at the level of lip service, but hate it at the level of implementation. Politicians need to craft the message – don’t come in talking Keynsian and say we want to raise the deficit, say our bridges are falling down or people are starving.”

Similarly, in Europe Blinder thinks it should be abundantly clear that fiscal austerity doesn’t work.

“This is an opportunity for investors to be suppliers of capital,” he says. “If I was a Belgian investment fund, I would think of sending money to the US.”

From a monetary point of view, Blinder was one of the economists who advocated that the European Central Bank was the only institution that could stand behind the euro.

It is astonishing to him now that president of the ECB, Mario Draghi, just had to pledge that “he’d do whatever it takes”, without actually doing anything and have an effect.

“It’s a great time to be teaching economics. Unconventional monetary policy; it’s a new field.”

Blinder, who was vice chairman of the board of governors of the Federal Reserve System from June 1994 until January 1996, is the Gordon S Rentschler Memorial Professor of Economics and Public Affairs at Princeton University. He was also a member of former president Clinton’s original council of economic advisers.

His latest book, After the Music Stopped, looks at the 2007 crisis, asking not who done it but why they did it.

In organisational terms there isn’t a stone unturned at University of Toronto Asset Management (UTAM). The organisation has a new board, new staff, new risk and reporting systems and has restructured its portfolios, including a new policy portfolio.

Where previously the assets were managed in a traditional method, with public market assets and alternatives allocated across a benchmark portfolio, now a low-cost passive reference portfolio is the starting point for investments. The portfolio is assessed in risk-driver terms including equities, interest rates, cash, inflation and currency.

The settings

This passive, low-cost easily implementable reference portfolio was set at Canadian equities 16 per cent, US equities 18 per cent, international developed market equities 16 per cent, emerging markets equities 10 per cent, credit 20 per cent and rates 20 per cent.

Of course the actual portfolio in 2012 was quite different to the reference portfolio, with UTAM “believing” in active management.

The actual allocations at the end of 2012 were Canadian equity 15.9 per cent, US equity 17.9 per cent, international developed market equity 16.4 per cent, emerging markets equity 10.2 per cent, credit 19.8 per cent, rates 10.9 per cent and absolute return 8.9 per cent.

“We have changed the place quite considerably in the past four years,” Bill Moriarty, the chief executive and president of UTAM, says.

“We have gone to a simple reference portfolio concept. It’s easy, implementable and passive. What drove the allocations was the risk tolerance and budget of the organisation. We also acknowledged that risk, in terms of volatility and other risks, is not static, so the risk budget should be reference portfolio plus an element of active management,” he says. “We looked at it as beta risk and active risk, then created a portfolio around that.”

Once the reference portfolio was approved, he says the team “looked inside each area and then found the best way to gaining exposure to the risk over time”.

“It gave us the basic beta portfolio, then we look at whether we can build a better beta portfolio with strategies and then we think of the best managers,” he says.

University of Toronto Asset Management manages three pools of money on behalf of the university. The endowment and pension portfolios have a target return of 4 per cent plus CPI, the target of the Expendable Fund Investment Pool, which is the university’s working capital pool, is the 365-day Canadian treasury bill plus 50 basis points.

Positioning risk

Over the past 12 months UTAM has also implemented a position-based risk system, which went live in December 2012.

“I have more grey hairs than I did a year ago,” Moriarty says. “This is easier to implement for traditional long-only strategies but is more complicated with hedge funds and privates.”

University of Toronto Asset Management has also been working with Morgan Creek Capital, which is an investment adviser, built specifically to advise clients on the endowment model.

It has used State Street’s web-based truView market risk-management tool, which feeds into other international fund services applications, and is specifically aimed at the needs of hedge funds and hedge funds of funds.

“The hedge fund strategy is an evolving area where we are working with the university,” he says.

“On the private side, we pulled apart the commingled funds to understand the investments, proxied them with public investments and everything was put into portfolios. It means we can now look at our allocations across, say, regional or industry concentrations.”

“This has taken a lot of time to implement. We’ve found it very useful, and it’s told us some things that weren’t obvious, like some of our currency risks weren’t quite as obvious from the top down as when you look at granular level.”

The foreign currency hedging policy has also been changed, and is now set between 5 and 25 per cent of each portfolio’s total value.

One of the results of the new risk allocation model is that the portfolio is very underweight interest rate risk.

“Our rates exposure is now half of the policy portfolio and we have no exposure to high yield,” he says.

Performance plus

Moriarty is proud of the team’s performance, which he says has been steadily improving relative to the benchmark over the years.

Tens of millions of dollars in costs have been taken out of the portfolio as it comes up with strategies to create a better beta portfolio. Despite that, UTAM still has a large number of service providers, with more than 50 managers under the growth/equity critiera, 22 in income/credit, two in rates and 11 in the other category.

One of the enabling factors for all of the change at UTAM has been a new governance structure.

A large board has been reduced to five directors, which deals only with operational risk, strategic vision and budgets. The university has an investment advisory committee, with investments delegated to and implemented by UTAM.

“This structure focuses the board on the critical elements of managing the portfolios, which is setting the long-term risk and return targets,” he says. “Before the board was much larger and there was perhaps some lack of understanding or explicit statement of responsibility.”

Geraldine Leegwater, ABN AMRO Pensioenfond’s director, talks about her fund’s investment strategy process with a matter-of-factness that possibly belies how far it has moved established ground. While Leegwater sees logic at every vantage point behind the changes that she helped to introduce at the Dutch banking giant’s €18-billion ($24-billion) fund in 2007, she skips from one of its remarkable features to the next.

The most innovative part in her view is the setting of the fund’s strategic asset policy. The ABN AMRO pension fund trustees theoretically wipe the slate clean and pick their favoured policy from a wide-ranging list of 10 options every 12 months or so.

To keep any subjective views on asset classes out of the equation, the options are presented to the board of trustees purely on the basis of figures representing the most relevant criteria for them, such as indexation potential and downside risk. The underlying asset mix is then only revealed after the most suitable option is chosen from the range of projections. Leegwater recounts how there were some shocked faces at times in the first few years when the underlying strategy was unveiled, but these would fade when the reasoning was discussed. Regular asset-liability management studies are conducted, after all, to inform the risk-return forecasts at these all-important strategy meetings.

The trustees are nonetheless given the chance to launch a radical break in strategy on an annual basis. “The goal of our trustees – to generate sufficient return to pay indexation to participants with the lowest risk – has remained the same over the years, but the amount of investment risk you need to achieve this goal can differ over time,” Leegwater explains.

Remarkably though, the risk return-focused process has led the fund to continually reselect a dynamic liability-driven investment (LDI)-based asset allocation strategy. This has been in place from the first decision meeting under the new structure in 2007 to the most recent in December 2012.

Dynamics, not tactics

The LDI component of the strategy has resulted in a familiar separation of assets into matching and return portfolios. The matching portfolio invests the majority of the funds’ assets in interest-rate swaps, government bonds and highly rated short-term paper.

The return portfolio is the smaller alpha-seeking segment. It is dominated by developed market equities (70 per cent) with smaller emerging market equity, corporate credit and real estate buckets taking 10 per cent each.

The weighting between the matching and the return portfolios is set at the strategy-selection meetings and, like the investment strategy itself, can be revised dramatically. An increase in the return portfolio from 14 per cent to 43 per cent throughout the course of 2009 is the best evidence of that. Leegwater explains that this leap was made as during the selection meeting it became clear that a higher allocation to the return portfolio was required in order to achieve the goal of the board of trustees for a high indexation potential against acceptable risk.

The current dynamic strategy is such that during the year the matching portfolio is fixed to a set level. However, the dynamic element sees the weighting of the return portfolio float in relation to the latest funding ratio at predetermined rebalancing moments during the year. The exact consequence of a given funding ratio for the return portfolio is determined by the annual strategic asset allocation decisions. All in all, this helps to ensure that the focus is on the primary goals of the fund at all times.

Leegwater explains that an intriguing consequence of the dynamic asset allocation approach is that the natural bias of the strategy is for pro-cyclical investing in between the usually counter-cyclical moves at the yearly strategy meetings. This approach seems to be working well for now, with Leegwater happy to let the structure run its successful course. However, she is fully aware that this is dependent on the behavior of financial markets, with high volatility presenting a risk between annual strategy-setting decisions.

Another consequence of the dynamic strategy is that Leegwater and other managers have no tactical asset allocation calls to make whatsoever, and can therefore focus on liability projections. Leegwater is content with that too. “We don’t have any illusion that we can beat the markets,” she says, conceding the approach is not dynamic enough to react to rapid changes in markets as the portfolio is assessed only a few times per year for deviation from the planned strategy. Nonetheless she argues that each strategy-setting meeting offers a chance to compensate from any unintentional surfeit or deficit of risk taken into the portfolio over the last year due to market biases.

The refusal to make tactical investment calls means that the weightings within the return portfolio are followed entirely without any under- or overweightings.  The strategic make-up of the return portfolio is currently under review “and if we find a portfolio with more efficient risk-return qualities, that will go under consideration”. Leegwater admits that this could see alternative asset classes make an appearance in the ABN AMRO fund’s portfolio.

Liberated leverage

When Leegwater says that the fund has around 80-per-cent exposure to the matching portfolio and another 40-per-cent exposure to the return portfolio, it is obvious that an added piece of financial wizardry is at play. The ABN AMRO fund leverages it assets, an action it first embarked on in 2009. Leegwater says the fund is not unique in leveraging its assets, but possibly unique in openly reporting it. “I think there are many pension funds that have, say, a 50-per-cent fixed income and 50-per-cent return portfolio and state they are hedging what they call 70-per-cent of the liabilities,” she says.

Leegwater explains that the leveraging can be gained by investing in interest-rate swaps that don’t require up-front funding. Interest-rate swaps are a necessity for a Dutch pension fund looking to hedge risk on long liabilities, she points out. Leveraging is a position that has its natural limits though, as it requires both sufficient liquidity (interest-rate swaps expose a fund to short-term interest rate movements) and collateral.

Flexible fund

Altogether the approach has led the ABN AMRO fund to a fairly serene position for the time being. The latest funding ratio is 119 per cent under new Dutch central bank criteria – ahead of the 114 per cent legislated solvency target – although the funding ratio is a more modest 111 per cent in the fund’s own calculations, based on market rates.

The healthy surplus has seen steadiness become the current flavour of the dynamic strategy, with only minor changes made to the size of the return portfolio in the past year. The surplus contributed to a decision for the risk appetite to be slightly lowered by reducing the return portfolio at the last strategy-setting meeting in December. “The better the coverage ratio, the less excess return you need,” Leegwater points out, despite conceding that the fund’s capacity to take risk has also increased.

Few could argue with Leegwater’s reasoning when the ABN AMRO fund boasts investment returns of 14.3 per cent for 2012 and 16.1 per cent in the difficult year of 2011. While Leegwater reckons much of the success of the new investment structure and dynamic strategy came from its flexibility to shed risk at the right time, the complex pension solution is fully answering its sponsor’s needs for now.