Austria is a country with a strong tradition of innovation. That can be sensed through its nineteenth century industrial emergence to Gustav Klimt’s secessionist art movement in turn-of-the-twentieth-century Vienna and the Austrian school of economics that later spawned monetarist pioneer, Friedrich Hayek.

The APK pension fund is these days adding to the list of those Austrians challenging conventional wisdom.

APK chief executive, Christian Böhm, explains that the €2.4 billion ($3.1 billion) multi-employer fund is “not a benchmark investor”.

Böhm is no fan of the rigid portfolio structures typical of continental Europe and no asset class is taboo.

Value and implementing assets into APK’s risk profile are the only limits.

This leads to a hands-on approach that utilises APK’s internal management operations – as well as managing around 25 per cent of assets internally, mainly in government bonds, the fund runs its own currency overlays.

“We are 100 per cent responsible for the whole portfolio, and we look at the whole picture all the time, every day”, Böhm adds.

 

Recognising value

One of the ways in which APK has caught the investing world’s attention in recent years was in buying distressed US mortgage-backed securities into its portfolio.

The subprime securities never totaled more than 1 per cent of APK’s bond portfolio. They have offered a good cash flow and good nominal returns, Böhm says, and APK has since largely cashed out of these positions.

Böhm says APK leapt into the troubled securities in the aftermath of the financial crisis when realising “there was an image factor deterring other investors” and leading to undervaluation.

Böhm believes that “if you pay attention to the valuation figures, keep an open mind and have a good access to the markets, you can identify a lot of assets offering good opportunities.”

In an investment environment with low returns, “this is a necessary exercise”.

 

Beyond the boundaries

APK has also been noted for making ambitious moves into emerging markets.

Over 70 per cent of the fund’s $1.04-billion equity holdings are in companies outside the eurozone.

The fund went overweight on Asian stocks in 2011, along with US equities, while the euro crisis began to play out. It also moved into emerging market bonds as a substitute for bonds in troubled eurozone countries such as Ireland, Portugal and Greece.

Böhm says that APK has been further increasing its emerging market portfolio, but tailoring its composition as it gains experience in the asset class. The fund has recently been reducing its exposure to “overvalued” emerging economies.

“We have to be wary of a lot of things with emerging markets, particularly markets that are strongly tied to commodity prices”, he explains.

 

Sticking to a value-investing approach

Innovation at APK takes place around what is a conventional-looking core portfolio, with 42 per cent of assets in bonds and 31 per cent in equities.

Chunky positions are taken on both money markets, in which 13 per cent of the fund is placed, and absolute return, which accounts for 10 per cent.

The fund’s interest in alternatives comes from its pessimism in the potential for investing returns in classic asset classes.

“We take a broad view on alternatives. We always try to beat our bond returns with lower risk assets,” Böhm says. “That means we need alternatives that sit well with our long-only portfolio.”

Sometimes APK’s interest in an asset class runs up against its golden rule of sticking to a value-investing approach.

Böhm speaks of APK’s desire to increase its real estate portfolio in the long run, currently a modest 4 per cent at roughly $124 million. But, he says, “not at any time or at any price”.

He explains that “at the time being it’s not easy for us to identify real estate investments with very reasonable prices, so we look for certain niches.”

Is a major investor situated in the center of Europe not well placed enough, though, to take advantage of the continent’s struggling real estate markets?

Pension funds like APK have traditionally focused on European office and retail real estate markets for both investment and regulatory reasons. Böhm feels that a resilient core office market “isn’t a good option at the moment” and retail holdings are the ones APK has found itself concentrating on recently.

 

Super returns

Over the past year the most significant changes at APK have been a reduction in the fund’s eurozone bond portfolio. Government bond holdings have been reduced to the Austrian regulatory minimums, with corporate debt being bought up as a substitute.

Emerging market, high yield and investment grade bonds are other types of debt that Böhm says APK has been “very active in”.

APK has also implemented an overlay strategy in its equity portfolio to limit risk.

The pension fund will soon be able to publish its 2012 performance figures and Böhm indicated that these should be very good, barring a major upset before the end to the year.

Up until the end of the third quarter, the fund was outperforming the rest of the Austrian market by as much as two percentage points. Importantly, 2012 should allow APK to post positive returns after a minus 2.5-per-cent performance in 2011 – although that was still better than the Austrian pension fund average, as Böhm likes to point out.

The overall performance figures are not the most important for APK’s employer customers, who are bundled into different accounts. Several of these accounts boast double-digit returns so far this year, Böhm says. With returns like that, even more investors might pay attention to APK’s future innovative investment moves.

 

In the paper Pension Funds, Sovereign-wealth Funds and Intergenerational Justice from the Norwegian School of Economics, those Scandinavians have come up with something better than the national alcohol monopoly: a natty new finance term. “Intergenerational justice” (try saying it thrice after a glass of aquavit) seems to refer to a combination of two things: a nebulous financial security that sovereign wealth and pension funds can deliver to us, our children and even theirs, as well as an underlying assumption that this sustainable financial security is a moral obligation shared by all stakeholders.

Try another glass, I mean sip, of aquavit.

The paper states that these funds “represent an increasingly important group of shareholders” and that their financial success is of keen interest to future generations. The authors consider diversified portfolios and long time horizons crucial to the nature of these funds and describes the main obstacles to their “shareholder democracy”. These obstacles get in the way of sustainable development, which is of course the herald of intergenerational justice.

The paper is a questioning of the corporate governance structure at sovereign wealth and pension funds, and a sensible nudge for it to serve the interests of intergenerational justice. Read on in your best interest.

It has been a bad month for credit-rating agency executives who thought they were winning the legal and regulatory arguments about how they conduct their business. In Australia, the Federal Court ruled on November 5 in favour of 12 local councils in New South Wales which claimed that Standard and Poor’s had misled them into losing A$16 million ($16.8 million) on a complex debt security they bought in 2006 by stamping a triple-A rating on the product. On November 12, prosecutors in the Italian town of Trani demanded that seven employees at Standard and Poor’s and Fitch should stand trial as part of a probe into alleged market fixing when Italy’s sovereign debt was downgraded last year.

New rules for credit rating agencies

While these stories made the headlines, the credit rating industry could yet suffer an even bigger reverse at the hands of European Union officials and legislators. By the end of 2012, the European Commission, the European Council and the European Parliament aim to conclude negotiations aimed at introducing new Union-wide rules for credit rating agencies early in the new year. Their overarching goal: changing the system for rating the sovereign debt of EU member states.

“Ratings help investors who are interested in buying government bonds by providing guidance about where they should allocate their capital,” says Leonardo Domenici, the Italian socialist member of the European Parliament who is leading the attack in Brussels against the present sovereign-debt rating system. “What has to be avoided is the risk of speculative ratings and a situation where the agencies dictate the policies of a state.”

If Domenici has his way, the new rules will ban agencies from publishing unsolicited sovereign debt ratings or communicating any policy prescriptions to EU governments as part of the grading process. In addition, Domenici is lobbying for the EU to reduce the dominance of Moody’s and Standard and Poor’s, which together control more than 80 per cent of the worldwide credit-rating market. He proposes that any government or corporate bond issuer in the EU requiring more than one rating on a security would have to choose at least one agency whose market share is below a defined level. In practice, that would eliminate either Moody’s or Standard and Poor’s. Even Fitch – the smallest of the big three, with about 15 per cent of the market – might be caught by the rule, if the level was set sufficiently low.

“The goal of the European Parliament is to allow greater market competition, through the participation of smaller credit rating agencies in the process,” explains Domenici.

The proposals tabled by the European Commission and the European Council are scarcely less radical. The Commission wants the sovereign debt of EU member states rated on a regular six-monthly basis, rather than once a year, as is currently the norm for some countries. It also suggests that “to avoid market disruption, sovereign ratings should only be published after the close of business and at least one hour before the opening of trading venues in the EU”. Meanwhile, both the Commission and the Council advocate that debt issuers rotate their credit rating agencies every three years to increase competition and transparency.

Popular policy

Brussels is renowned for ambitious legislative proposals that either get stuck in the EU’s labryinthine bureaucracy or are drastically diluted in order to achieve consensus among member states. On this occasion, however, investment managers that use ratings to help determine their exposure to European fixed income should not assume all the talk in Brussels about overhauling the process will come to nothing. In crude political terms, going after the credit rating agencies is a winner at a time when resentment festers across the EU about the perceived role of Standard and Poor’s, Moody’s and Fitch in worsening the region’s sovereign debt crisis.

In this regard, the prosecutors in Trani are tapping into the same vein of hostility that has cast the agencies as arrogant, irresponsible actors that release sovereign debt downgrades just when vulnerable EU states can least afford them.

“We are trying to develop some long-term vision on how to deal with overreliance on credit rating agencies, not produce a quick fix,” says Sharon Bowles, the British Liberal Democrat Member of European Parliament, who chairs its economic and monetary affairs committee. “All sides of the European Parliament are reasonably together in trying to achieve this [goal],” adds Bowles, also a candidate to succeed Sir Mervyn King as the next governor of the Bank of England.

Even northern EU countries that have preserved their triple-A sovereign debt ratings believe the time has come to change the whole process. In the Netherlands, for example, “the Dutch government supports new European regulation on credit rating agencies… especially when it comes to reducing over-reliance on ratings,” says Ben Feiertag, a spokesman for the finance ministry.

Rear-guard response from ratings agencies: nothing wrong

Faced with the prevailing mood in Brussels, the main rating agencies have mounted a rearguard action in defence of their view that there is nothing wrong – and plenty right – with the way they grade sovereign debt in Europe.

“Ratings have been a stabilising force during the history of the eurozone,” says Martin Winn, Standard and Poor’s chief spokesman for Europe. “For many years up until the recent crisis, the market viewed southern European sovereign debt on a par with German AAA-rated bonds, while we always rated countries such as Greece, Italy and Portugal significantly lower and we downgraded them further in 2004–5. This overshooting by markets contributed to the imbalances that developed in the eurozone.”

The agencies also reject the notion that unsolicited sovereign debt ratings are, by definition, unwanted. “Unsolicited ratings should not be discouraged or stigmatised,” says Daniel Piels, Moody’s senior European spokesman. “Credit rating agencies must be able to provide their opinions in the market, whether requested by the issuer or not, and unsolicited ratings should not be positioned as the poor relation of their solicited counterpart.”

No change at all is not an option

Many fund managers – eager for the best and most recent analysis of sovereign debt issuers  – would agree with that view. Among investor organisations, there is also concern that any new regulations will inject more problems into the system. For example, the European Banking Federation, while broadly supportive of the Commission’s proposals, opposes rotation of agencies because Moody’s, Standard and Poor’s and Fitch each have different rating methodologies.

Yet the debate in Brussels has already gone beyond the point where no change at all is an option. In any case, the agencies are hard-pressed to defend the present absurd system, where both they and members states claim for self-serving reasons that the ratings are just opinions, while investors largely take them on trust. This charade was played out again on November 20, when Moody’s downgraded France’s sovereign debt from Aaa to Aa1. The French finance minister, Pierre Moscovici, responded by telling investors to “judge us on our results” and the yield on a 10-year French government bond promptly rose two basis points (that is, O.O2 per cent) when markets opened.

The truth is that European governments and the agencies have a mutual interest in operating a sovereign-debt rating system that both can agree is robust, transparent and credible. That suggests three likely outcomes when the new regulations are finalised. First, as always happens in Brussels, the rules will be the product of a compromise. Second, the compromise will reflect at least some of the views advanced by investor groups for not undertaking root-and-branch reform. And third, unlike many EU compromises, this one will still have real substance.

The UK’s £3.3-billion ($5.6-billion) Merchant Navy Officers’ Pension Fund (MNOPF) is poised to offload the final portion of its defined-benefit liabilities in the old section of the scheme. The fund, which has provided pensions to the shipping industry since 1937, comprises a $3.2-billion new section and a $2-billion old section, closed since 1978 and with around 22,000 retired members. Galvanised into action when funding levels plummeted to 81 per cent in 2008, the MNOPF insured a total $960 million of its old section in two separate deals with insurance group Lucida. Now, to counter all investment and longevity risks within the old scheme, the balance is likely to be insured by a third party too. “Subject to market conditions, we are close to making a decision regarding the buy-in of our remaining liabilities in the old section,” said MNOPF chief executive, Andrew Waring, who took over the helm in 2008, joining from Benfield Group.

The next step in Waring’s risk-averse, insurance solution will be keenly watched by the many other UK schemes weighing up the best way to handle the headache of ballooning pension liabilities. He’s convinced it’s the only strategy to meet the MNOPF’s $160-million monthly pension obligations and safeguard against the old section’s deficit landing on the balance sheets of the thousand-odd diverse employers that stand behind the scheme. The old section is currently 96 per cent funded on an all-gilts basis.

The multi-employer MNOPF scheme is a last-man-standing fund whereby the liabilities from any employer withdrawing from the scheme are reapportioned among those that remain, increasing their share of the deficit. Although Waring jokes how employers “visibly pale” when they understand the principle behind such a scheme, he is adamant the MNOPF’s structure, shared by other UK schemes including the $48-billion Universities Superannuation Scheme, ensure a particularly robust constitution. Waring’s particular challenge is that although the old section has around 3500 employers comprising all types of seafarers from oil companies to ferry operators, the fund can only track 250 of them. It’s a problem that has bled into the new section too. It has 350 employers but the last valuation showed that around 25 per cent of all liabilities in the scheme are now so-called orphan liabilities, ultimately forcing the MNOPF to call on its employers again.

In a process Waring calls “taking chunks of risk off the table”, Lucida first took on $797 million worth of liabilities in 2009, then a further $160 million in May 2010. “Half our liabilities in the old section are now extinguished. If we don’t approach risk like this, we are putting at risk the accrued benefits of our members,” he says. He’s just as determined not to call on the support of the UK’s lifeboat fund, the Pension Projection Fund, as he is to not impose “unreasonable funding obligations” on the schemes’ remaining employers. “The idea that if we get into trouble the PPF is always there isn’t a view I share,” he says. “We don’t want to use it because we need to work though our last-man-standing principle.”

New fiduciary management

In another strategy, again born from conservatism and caution but which has also grabbed the headlines and differentiated the MNOPF from peers, Waring has overseen the introduction of a new fiduciary management at the fund. The fund outsourced investment management to Towers Watson in 2010 and appointed Hymans Robertson as independent investment advisor to oversee Towers in 2011. Although the MNOPF investment committee, which meets five times a year, still decides on basic strategy including asset class and allocation, plus the size of the risk budget, Towers Watson oversees the rest. This includes hiring and firing managers – the number of managers has grown to 30 from 15 since Towers Watson took on the role – and negotiating fees on the scheme’s behalf. “We don’t have any resources for an inhouse investment team and the investment world gets ever more complicated,” he says. “Because of the way the fund is structured, members and employers sit on our board.” The old section is invested in a passive, low-risk strategy that targets 105 per cent funding over 10 years on a gilts basis. Growth assets include equity, investment and non-investment grade credit and property.

Strategy for the new section, which is between 60-70 per cent funded, also veers on the side of caution. Assets are portioned in global equity (20 per cent), private equity (4 per cent), hedge funds, including a distressed-debt allocation (10 per cent), property (3 per cent), commodities (2 per cent), reinsurance (3 per cent), non-investment-grade credit (8 per cent) and investment-grade credit (12 per cent). There is a 35 per cent matching asset allocation and 3 per cent in emerging market currency. The fund recently cut its equity exposure and increased its private equity and re-insurance allocations. “Our time horizons are a bit short for pure infrastructure,” says Waring. “Early stage infrastructure fits other funds better than the MNOPF – even our new section isn’t as new as it once was.” He says the fund is now robust across all possible scenarios rather than taking a bet on one particular asset class. Since the new management structure was introduced, returns have increased and risks reduced. The new section outperformed its 7.8-per-cent benchmark by 0.9 per cent over the year.

How to wind up

Waring says that other funds mulling a similar wind-up should focus on how best to present the fund to the insurance market. “Watch out for skeletons in the cupboard,” he advises. “There could be things lurking in dark corners that newer trustees wouldn’t be aware of.” For all his enthusiasm he warns that wind up is an emotional, “gut-wrenching” journey. He says the MNOPF is a club that members like belonging to; they won’t have the same affiliation or sense of trust with an insurer.

But he’s still resolute that with a mature scheme like the MNOPF, the downside risk is always greater than the upside potential. The MNOPF has less freedom than other funds; shifting more of the portfolio into return-seeking assets wouldn’t solve the problem. He talks about compromise and the balance that he’s had to strike between the fund’s diverse members. Some are big corporates, strong enough to withstand short-term volatility seeking long-term equity investment, but others are small ship owners with a low threshold for risk. “We traded in upside potential for security. It was a tough decision but we decided security was more important,” he says.

When the Netherlands pension reforms were announced in 2011, many experts argued they were likely to substantially increase the risk appetites at the funds guarding the country’s $1-trillion pension assets.

Recent developments to the reform proposals make the overall impact far from clear, however, suggesting there will be no bonanza for Dutch investment managers. The pension funds themselves are not indicating any major changes to their investment mix, although the possibility of future changes resulting from the reform measures remain. Any impact on investment is intended as a by-product by the Dutch ministry of social affairs, which regulates pensions.

Helping pension funds cut benefits without the burden falling too greatly on any age group and keeping contributions at current levels were the driving motives.

The reforms are nonetheless set to relax some key restrictions on pension funds that have helped cement a conservative investment approach in the Netherlands.

Centrally set guarantees on members’ pension entitlements are to go, even though these are only nominal. In their place will come the freedom for funds to set their own pension promises. Granting more freedom for funds to chase returns and acknowledging the inherent risk in pensions via longer recovery plans both give the green light for funds to acquire more risk. At least that is what many argued.

Risky ambition

The state secretary for social affairs, Jellejetta Klijnsma, acknowledged the complexity of the reform project when she announced the new rules would be delayed until 2015.

“The development of the new legislation is taking more time than was anticipated. The issue is highly complex and is an important topic which I wish to approach cautiously,” she said, adding there will be a pilot introduction starting in January.

The reforms are set to allow nominally defined-benefit (DB) funds to share investment risk with members, by becoming hybrid defined-ambition (DA) schemes. That also promises to take Dutch funds away from their cautious investing stances – a choice that rests very much with the fund, explains Aegon’s David van Bragt.

He confirms that “if a fund chooses the ‘soft DA contract’, there will be more room for long-term investing”, adding though that there is plenty of uncertainty as to whether existing rights can legally be transferred from a DB to a DA contract.

Van Bragt says that “jurisprudence and practical experience will probably first have to develop further before many funds will switch to DA and redefine their investment policy”.

Another potential snag is that while many pension funds might welcome the long-term benefits of moving more into equity markets and alternatives via a DA arrangement, they might need to impose short-term benefit cuts to do so.

This is a result of the poor funding status at many Dutch funds, van Bragt explains.

The average Dutch pension fund was 3 per cent underfunded at the end of September 2012.

“This will be hard to explain to existing members as they are used to the hard benefit promises,” Van Bragt says, “so I expect there to be plenty of debate if funds are to press on with this.”

Bart Oldenkamp, managing director of fiduciary managers Cardano, says that pension funds should also tread carefully in gauging the risk appetite of members before passing the risk of an altered investment mix onto them.

If you add to that the probability of DA pensions having inflation-linked return targets, then a sea change in investment strategy looks unlikely.

To further muddy the water, those pension funds deciding to remain DB (with the Dutch provision of being able to cut benefits to match liabilities with assets) look set to face stricter capital requirements that may temper any demand from them for high risk assets.

Van Bragt has done a detailed analysis of the capital requirements for funds that chose to remain defined benefit. He reckons there may even be “some degree of de-risking” with bond allocations actually rising further.

In everybody’s interest

Some of the initial expectation that the new legislation would push funds into riskier assets was based on proposals for a new discount rate for the Netherlands.

Intense debate since the reforms were first outlined in 2011 resulted in a compromise discount rate being temporarily adopted in September 2012.

The initial proposals for use of the ‘ultimate forward rate’ common for Dutch insurers raised fears of a drive-out of long-term bonds.

These fears arose because the formula, as was first proposed, discounts any cash-flow maturities with a duration of more than 20 years.

A modified ultimate forward rate was adopted, which van Bragt says has largely eliminated these concerns.

Trimming the hedge?

Van Bragt thinks that the use of the modified ultimate forward rate could lead to a reduction in interest-rate hedges by pension funds.

“We have not seen very large movements so far – although some long-maturity swaps were rolled back to shorter maturities,” he says.

According to a 2011 Dutch central bank analysis, the level of interest-rate risk hedged at the largest funds ranges by 35 to 40 per cent. The analysis found that short-term interest-rate changes (for the next five years) were fully hedged.

While an accounting basis now shows many Dutch pension funds to be over-hedged, there is plenty of sentiment in the industry that most funds will appreciate that the fundamentals that led funds to hedge at the current levels has not changed.

A side effect of the modified discount rate has been an overnight increase in the funding status of Dutch pension funds, from around two to as much as 10 percentage points.

That has led to some new worries that investors will be lulled into a false sense of security and fail to moderate risk.

Waiting game

Investors emphasise that they will not judge the impact of the reforms until all the crucial details are hammered out. The €124.9-billion ($159-billion) PFZW fund said it is close to gaining clarity on the reforms’ consequences.

Another giant fund, the $340-billion ABP, is also waiting to see what the reform package will bring exactly. A spokesperson said that the fund expects any significant change to come in its interest-rate hedging rather than investment strategy.

ABP had around $935 million invested in interest-rate and currency-hedge overlays in 2011.

The spokesperson admitted that ABP was under-hedged in comparison to other funds as it was seeking to avoid locking in low market interest rates and not being able to absorb unexpected future inflation.

ABP regularly reviews its interest-rate hedging, and any movements in the wake of the pension reform will be sure to draw the attention of analysts.

The $16.6-billion Phillips Pension Fund has said it won’t change its investment strategy in the wake of the reforms.

The reforms still need to be approved by the Dutch parliament in The Hague, but are now set to be introduced in 2015 after a pilot program beginning in January 2013.

Some funds are already exploring the chance to move to the new DA status by opening up a dialogue with members, says Oldenkamp.

 

If it ain’t broke, don’t fix it

Dutch funds currently invest an average of 67 per cent in bonds as opposed to just 24 per cent in equities, according to Mercer.

Only pension funds in Portugal, Denmark and Norway have lower equity exposure, according to the consultants’ 2012 European Asset Allocation Survey.

A conservative discount rate based on long-term interest rates has led Dutch funds into strong positions on government bonds in particular, which make up 54 per cent of the average Dutch fund.

Alternatives are another relatively small asset class in the Netherlands, occupying 7 per cent of Dutch funds on average. In both the UK and Germany, the asset class accounts for 12 per cent of pension assets, according to the Mercer survey.

The reforms might do little to change this relative disinterest in the riskier asset classes.

Given that the Dutch pension system continues to be rated in various studies as the most dependable in the world and that Dutch funds returned 8.2 per cent in 2011 compared to an OECD average of -1.7 per cent, that might prove to be no bad thing.