Dutch fund ABP - the largest pension fund in Europe with assets of e180bn - has made sweeping changes in the way it runs its portfolio in the last three years. The portion of its equities that was run on an indexed basis - 45-50% - was reduced to zero, and equities are now 100% actively managed.
Active management has changed in many ways in the last 10 to 15 years, says Jan Straatman, capital markets CIO at Dutch pension fund ABP.
“In the nineties, it was sufficient to use passive exposure to capital markets because they produced quite adequate returns,” he says. In most cases, from pension funds’ point of view, both equities and fixed income exceeded the return requirements stipulated by the liabilities, he says.
But at the beginning of this millennium, funding issues for pension funds combined with low return expectations have meant that active returns have become more dominant than before.
Straatman cites several reasons why passive investing has lost favour with strategy setters at ABP. “We had some serious problems with benchmark investing on the back of accounting,” he says. The ENRON scandal in particular highlighted the danger of passive portfolios; investors who simply follow an index without having any further clue as to what they are investing in are highly exposed to risks like this.
Also, many segments of the overall investment universe - markets, asset classes, regions and styles - have become very competitive and it is hard to achieve outperformance within them. “In order to be able to outperform, you have to be able to focus on inefficiencies and be willing to invest outside your benchmark,” says Straatman.
Hedge funds, too, have risen in importance. In many cases, they are now considered to be another asset class. Hedge fund managers, says Straatman, are basically a group of managers who understand that in order to profit from financial markets, it is necessary to look at the inefficiencies within asset classes.
Similar to equities, fixed income benchmarks have become very efficient. “To that extent you can say benchmarks are of questionable use in our industry,” he says.
Following indices can expose an investor to the most indebted issuers. “Fixed income benchmarks by composition are very much driven by the need for debt by corporations and governments…taking a benchmark approach in fixed income leads you away from where you should be,” he says.
“I believe pension plans will move more and more to a position where absolute returns and total returns are more important,” he says.
In building its portfolio of strategies, ABP has been looking at them in terms of the inefficiencies those strategies are targeting, the correlation of the strategies, their drivers and their risks of failure.
As to whether there is any place for passive investment within ABP’s investment mix, Straatman says passive might make sense in certain circumstances within strategies to manage the overall risk budget. “We basically only look at passive strategies as a strategy in the total context of the portfolio,” he says. It is not a simple case of choosing active or passive.
In general, the scope for active management at pension funds is broadening rather than tightening, says Leo Lueb, director of equities at Dutch pension fund giant PGGM.
Investors are now looking more critically at the underlying business rationale of individual active management strategies. “Active management still plays an important role in todays low return environment as a way to meet performance objectives,” he says.
How does PGGM deal with the risks of active management? Where active management is used to generate alpha, the fund monitors risk on individual portfolios through tracking error techniques, which, says Lueb, is the most obvious choice and most used method.
“On a portfolio level, however, one should add risk management tools that look at the interaction between the different strategies,” he says, for example, the correlation between them. As well as this, one should do some serious scenario-analysis, he says, which includes looking at the stability of these correlations.
On the trend towards unconstrained portfolios, Lueb says this should only be an option for pension funds under certain conditions.
“Removing traditional benchmarks is only sensible if one has designed an alternative to measuring the effectivenes and, or, performance of a strategy. This in turn depends on what the investor is trying to achieve and how that relates to their investment beliefs.
Although much is spoken in modern investment theory about the separation between alpha and beta, Lueb points out that product offerings are now so diverse that the distinction is not always clear. “The industry offers an increasing number of ways that are expected to add alpha,” he says.
“In that process, both alpha and beta approaches enter overlapping areas and the conceptual differences between the two often become blurred.”
Investment strategy setters at Danish fund Industriens Pensionsforsikring very much like active management, says Jan Oestergaard, chief investment officer.
“It’s part of our philosophy that you should do active management,” he says, “But also, we make a marked distinction between the different regions of the world.”
A key part of the pension fund’s active management investment strategy is to split the world into five regions. Of course, implementing this strategy requires a considerable number of external managers, says Oestergaard, but IPF is a large enough fund to do this. The fund’s capital value is around e2.8bn.
“This way of doing things has been implemented almost fully for the last year and a half,” he says. Active management has paid off for IPF, he says, in terms of the alpha it has added.
However, there are some regions of the world, and certain investment segments within those regions where it does not pay to go for full active management. For example, US large caps, says Oestergaard. “The only way to have alpha in this segment is through enhanced indexing,” he sys. “There is a pretty high information ratio but that is because of the low risk level.
“It could be that in a few years, even enhanced indexing won’t be able to produce alpha in that region, but then in that case, it would be appropriate to move away from active in that area and towards indexing.” That, he says, is an example of how to have the right dose of active within a portfolio.
Dealing with bottom-line risk is an important pre-requisite when pension funds go in search of alpha. A number of pension funds have separated their management of beta and alpha, he notes, utilising the risk from their liabilities, with the aid of different derivatives, for example using the money market rate as the benchmark and then putting alpha on top of that.
But IPF has managed its risk differently. “What we have done since we are a very highly capitalised pension fund – we have a pretty high level of reserves…we have removed the risk of becoming insolvent, and at the same time we have kept the flexibility of an active strategy.
“We haven’t hedged the interest rate risk, but we have hedged the risk of becoming insolvent,” he says. The fund has decided that it can absorb the effects of a fluctuating interest rate level. Even if a Japanese scenario were to emerge, IPF knows that though its reserve level would be depleted, it would not be insolvent.
“We don’t want to give away the possibility of gains if the interest rate should start turning the other way,” says Oestergaard.
Sweden’s first buffer fund, Första AP-fonden, has recently revamped its scheme, taking more assets in house and under active management.
AP1 has now taken all its European equities investments under active internal management, with all North American equities assigned to external managers. This followed a major restructuring of the fund’s management mandates, the fund said in its first half report, which was completed in the first half of this year.
Spokeswoman Nadine Viel Lamare says these parts of the portfolio had been managed externally because when the fund was first set up, this was the best way to get market exposure quickly. The fund only began its global investment management in 2001, she says.
As to whether internal or external active management is preferable, Viel Lamare says this depends on the amount of profit left after costs. AP1 deals with the risks in active management by taking a well-diversified approach.
“We have a lot of different managers, asset classes, markets and investment styles,” she says. Risk can be high with active management if too many eggs are put in one basket, she says. “But that’s not the way we work.” AP1 monitor its managers very carefully, she adds.
AP1 cited the profit from active management as a factor behind its first-half net investment income of SEK13.1bn (e1.3bn). The return for the period was 8.4%, which it said was “aided by rising stock prices, falling interest rates and a positive contribution from active management”.
It has now named 12 new active emerging markets managers, including Aberdeen, BGI, Lazard, Merrill Lynch and PanAgora, although these mandates have not yet been funded.
On its website, AP1 said that the managers it has selected will give the fund good flexibility and portfolio diversification “together with a high expected risk-adjusted excess return net of costs”.
The managers complement each other well, it says, in terms of investment styles and risk profiles, and so they will contribute to the diversification of the portfolio.