Examining the complexity of individual asset classes, and their associated risks in combination, has been a major project for PGGM. Amanda White spoke to managing director investment strategy, Jaap van Dam.
One of the more important investigations going on in The Netherlands right now by pension fund boards, and their service providers, is the examination of the definition of investment complexity.
In addition to defining complexity, funds are determining what their individual dose should be, managing director investment strategy at PGGM, Jaap van Dam, says.
“After the credit crisis, several commissions discussing the pension industry in Holland, emphasised that pension fund boards should be in control, not only of the policy decision, but also of the implementation of the investment decisions.”
“I feel complexity has two elements. First, the number of different asset classes and sub-asset classes: how many different investment classes can be fully understood by the board? And second, the complexity of these asset classes in terms of implementation – such as operational, contractual and tax issues,” he says.
In the past 12 months PGGM, which includes the €90 billion ($127 billion) Dutch fund PFZW among its five clients, has undergone a project to classify its asset classes in terms of complexity, formalising a framework and identifying all the different types of risk within each asset class.
“We can now ask whether the complexity is worthwhile in terms of return and stability,” he says. “So, our clients will be able to make informed decisions trading off strategic investment decisions versus the level of complexity they find acceptable.”
PGGM on behalf of its client invests in more than 20 different (sub) investment classes, from six different identified sources of return and risk.
For PGGM, uniquely, investment allocations are a three-stage process which begins with an allocation to only four asset classes – equities, commodities, nominal obligations and inflation-linked – as a result of the ALM study.
This basic mix then goes on to van Dam’s strategy department and a more complex mix of investments – with the large majority in return-seeking assets – is created in line with the basic ALM. The objective of this process is to generate a higher and more stable return compared to the basic ALM.
PGGM’s asset class options are derived from six major sources of risk and return: equity, real estate, credit, other or complimentary risks, commodities and interest rate and inflation.
Van Dam says over the past five years the focus has been on further diversifying the portfolio in order to lower the impact of the dominant sources of risk.
“Equity has taken an enormous amount of risk and we diversify away from that. We are now looking at our pool of risk and the risk drivers of each asset class. Over the past year we have learnt collectively as an industry, liquidity is an issue and what asset class behaviour is under stress. So we’ve improved portfolio construction to be very explicit about what happens under stress and liquidity constraints and to test complexity,” he says.
The strategy department writes a formal investment case for all 24 asset classes, what the risk drivers are. In this document, a required rate of return per asset class is specified.
“Then the investment teams have to show that they can jump the hurdles of the required rate of return we set in strategy. The quality of the team drives the quality of the implementation, this is very important,” van Dam says. “It is the combination of the car and the driver that makes it work.”
PGGM has about 15 different investment teams, with a focus on autonomy of decision making and implementation. It uses a combination of internal and external management, with “clear and visible reasoning to why the decision has been made”.
“As part of a new office plan two years ago, PGGM said let the investors be the ones who invest, and looked at the teams to see what critical mass of people you need to deliver high-quality fully-credible investment management,” he says.
Van Dam credits chief investment officer, Johan van der Ende, who will leave in November, with strengthening the teams.
In 2008 PGGM became an asset manager and pension administrator , with the first steps towards becoming a multi-client organisation occurring in the past two years, and it now has five Dutch pension funds as clients.
“We want to be able to offer a whole array of investment solutions to all clients,” van Dam says.