Dutch see long-term value as TAA
As pension funds consider new ways of adding value to portfolios, an increasing number, particularly in the Netherlands, are turning to tactical asset allocation or TAA. Either as an overlay, or as an add-on fund, TAA promises additional returns within risk-controlled boundaries.
This summer, Dutch pension fund PGGM awarded a global tactical asset allocation (GTAA) mandate to Goldman Sachs Asset Management (see below). The mandate was for an overlay product, and the allocated risk to the portfolio was the equivalent of E1bn notional with about 4% tracking error.
GTAA has been very popular in the Netherlands, says Ruud Hendriks, head of institutional business development, continental Europe, at Goldman Sachs Asset Management. “In particular over the last two years, the interest in the product has increased dramatically as institutional investors see it as a good way to access sources of alpha that are uncorrelated to the traditional asset classes,” he says.
“We have seen a spread of interest for this product across various European countries. This is happening at different rates but it is definitely happening,” he says. “We have either funded mandates or are in discussions with clients
in Germany, Sweden, Switzerland, Ireland and Italy.”
Tactical asset allocation is now a widespread at pension funds in the Netherlands. Former investment consultant Philip Menco, who is now managing director of pension fund De Eendragt, says TAA normally takes the form of an overlay.
Funds typically set their strategic asset allocation for the year. Then the fund is granted room for manoeuvre, either as tracking error or as a percentage deviation from the strategic asset allocation. A 50% allocation for euro bonds, for example, might have a range of 45-55%, says Menco.
Of course, there are risks involved with any deviation from the strategic allocation. Menco says that in the first place, there is a risk that the manager might make a wrong decision and underperform the strategic benchmark.
“Then there is the risk of the product you hold – the derivative risk,” he says. “Not all participants in this have risk models which are able to cope with this type of risk.”
But an overlay is not the only way to go. Hendriks says that every GTAA mandate can either be interpreted as a funded mandate where the active risk is considered only relative to the assets in the GTAA portfolio, or as an overlay where the active risk is considered relative to the client’s overall portfolio.
Most Dutch pension funds employ tactical asset allocation, says David Tucker of Tactical Global Management UK, the UK arm of an Australian firm. “Certainly, if you take the top 10,” he says. “These days, it’s considered an alternative source of alpha within the overall risk budget. At the end of the day, it’s no different from a global macro hedge fund… it’s an uncorrelated source of alpha.”
Pension funds can access tactical asset allocation through a segregated account, where risk level is tailored to their requirements, or use a pooled vehicle, he says. The bigger pension funds may already have their own fund-of-funds currency manager, says Tucker, and in cases such as these, the tactical asset allocation requirement may solely be for equities.
The value to be gained from TAA depends on the risk the fund is prepared to take, says Menco.
Target returns for TAA at his firm, says Tucker, are 12-17% plus cash. Given that the average allocation to TAA for a Netherlands pension fund is 3-4%, this means it can add 75 basis points at a portfolio level.
The additional risk that tactical asset allocation puts on the overall portfolio, says Hendriks, depends on the amount of risk the client chooses to take in the GTAA strategy and the correlations between the GTAA strategy and the strategies of the underlying portfolios.
To what extent should tactical asset allocation take account of a portfolio’s existing strategic allocation in terms of diversification and risk reduction? Managing unintended risk resulting from portfolio drift, and the implementation of an alpha-generating GTAA overlay should, says Hendriks, be thought of as separate, independent steps.
It can be argued that the freer a skilled manager is, the more value they can add. “Therefore a GTAA overlay in which the opportunity set is not constrained by the asset class ‘buckets’ in a client’s strategic benchmark, has the potential to add more value per unit of risk than an overlay that is constrained by those ‘buckets’,” says Hendriks.
While strategic changes at pension funds are usually made only once a year, tactical moves are made more often. But the frequency varies from fund to fund. Menco says that decisions would mostly be made monthly with implementation perhaps daily.
“We’re rebalancing on a daily basis,” says Tucker. “We’re optimising all the time. We have a fundamental approach.” Some funds want additional hedging, and that is a bolt-on product, he says.
Although some pension funds are restricted in derivatives use, Tucker says that in the Netherlands, for the larger funds at least, this is not so. But even where derivatives use is problematic for the client, there are ways of dealing with it. “You can get around that by wrapping it up in a pooled vehicle… we’re not buying and selling derivative products on behalf of the client, but they’re buying into a Cayman-registered pooled vehicle.”
Tactical asset allocation has been part of Australian investment practice for years, says Tucker. “Australian pension funds have been ahead of the game for a long time,” he says. “We’ve seen a marked increase in interest in the UK, the US and Canada, but the Netherlands are leading as far as European investment is concerned.”
Dutch pension fund ABP uses TAA in two ways. It is carried out internally in overlay, as part of its central asset allocation process, and also via several decentralised hedge fund mandates, which are externally and internally managed.
“Central TAA to some extent has always been part of ABP's asset management business,” says Michel Meijs of ABP. The fund has been using TAA types of hedge fund strategies since 1997.
ABP reviews its centrally managed TAA active positions once a month, though there is not much change made to active positions from month to month. “We emphasise consistency and avoiding the psychology of the moment,” says Meijs. Strategic asset allocation, on the other hand, is reviewed once every three years.
Meijs says that TAA can add value, but because it concerns highly efficient markets, it is hard to outperform the long-term strategic benchmark consistently. Unless an investor has specific skills, the key is to look at fundamentals, to be consistent and patient, he says. “Short-term oriented TAA is senseless; in the short term asset returns are unpredictable.”
Through central TAA, ABP targets an additional yearly return of 5-10 basis points on average. There are additional risks, but these are restricted through a specific risk budget for central TAA.
The ING corporate pension fund uses TAA, and participates in the tactical asset allocation programme of ING Investment Management. The fund says that at ING IM, tactical asset allocation decisions represent the result of “a disciplined process in which we compare the present and expected relative attractiveness of equities and bonds, with the aim of adding value by adjusting the allocation to these asset classes”.
ING says empirical research has shown that TAA can be a significant source of added value, particularly for longer-term investors. “We target an Information Ratio of 0.25 on rolling three-year periods,” the spokesman says. “The alpha objective is 10-15 basis points annually.”
Risk management, says ING, is an integral element of every stage of its TAA. It ensures portfolio risk is allocated in a way that is transparent, intentional and consistent with its investment strategy.