PGGM's risk budget approach
The E57bn PGGM fund for the Dutch healthcare sector has always prided itself on being innovative and can point to a track record where it has taken a lead, going back to its major and early involvement in private equity and subsequently its commitment to commodity investment, among other steps.
Now it has taken the same approach in the area of tactical asset allocation, where it made the decision to change its strategy from in-house to an outsourced investment process.
During its review, PGGM took a thorough look at how it should tackle the area of tactical asset allocation: should it persevere with the traditional approach of handling it internally? “We wanted to see if there are other ways to successfully implement a GTAA programme,” says Marc Nuijten, manager of derivatives and overlay management. “On that basis, we started a fact finding mission.”
The fund focused on what the managers in the marketplace might have to offer by way of global tactical asset allocation products. “In particular, we wanted to get to know the factors that drive their processes.”
The first step was to ascertain whether there were products available in the market that would be attractive to PGGM, he says. “We then started discussions with potential managers and felt comfortable about using external managers as part of our tactical asset allocation process.”
Then the fund drew up clearly what its objectives were for the overlay management programme. “Here, it is essential to set out your objectives very clearly.”
One thing PGGM was certain about was that anything that was implemented would contribute towards the absolute performance. “We do not have a target as such. We have an ALM model resulting in our beta allocation, but on top of that we are trying to find innovative opportunities to strengthen our returns. Overlay management should increase the chances of achieving this, as generally such strategies will have a low correlation with our beta.”
PGGM did not approach these mandates along the lines of having a size of mandate in mind. Instead, it had a total risk budget which showed what could be allocated to the programme. “At the starting point we had thought we would go with three managers and divide the risk budget between them. Recently we decided to go for a fourth manager as this would give us more flexibility in managing risk over the implemented mandates.”
The manager universe for TAA products currently is not very large, with about a dozen or so players to be considered. “There is a small group of names that you hear about.” PGGM felt it had the internal resources to conduct the search itself, by using managers from different internal teams with the appropriate expertise.
In drawing up the request for a proposal (RFP), he says that some of the areas included were comparable to more traditional mandates: “What we were trying to get at is the different investment styles and processes of each manager, as well as setting out our requirements as to what we are looking for.” He says it is essential to be as clear as possible about what is being sought, when looking for more information than just track record and historical performance data.
From issuing of the first RFP to appointing the first manager took around six months. “We short listed just three managers for our due diligence process.” Then there was the implementation of these mandates, which were different to those normally issued in that they were not related to an amount of assets. “There wasn’t a notional amount of assets involved,” he explains. “We use VaR as a general risk measure. In this instance, the total risk budget available is E50m monthly VaR at a 95% confidence level.”
This budget will be spread among the four managers, so that with the three managers already in place, 75% of the budget is spent. The task is then monitoring the managers to see where their different strengths lie.
PGGM in a strategy that departed radically from normal practice did not allocate any cash to the managers as a result of the mandate wins. “We are using own facilities to take care of the whole administration of the derivative transactions used in the programmes,” he explains. All the confirmations, payments and other related operational tasks are handled by the operations department. “This creates a lot of efficiencies for PGGM.”
He feels this leads to much greater transparency and inevitably a closer and stronger relationship with the TAA managers. “This gives us an extra insight into the TAA managers’ activities. I believe this structure works very well for both sides.”
Goldman Sachs Asset Management was awarded the first mandate in September 2003. This was followed by Deutsche Asset Management’s win in November and in June, Bridgewater Associates being appointed for the third award. The final one is expected to be put in place in the first quarter of 2005.
What is most important in having a range of managers is that their styles are different. “Financial markets often show that diversification is not obtained when you really need it.” This will be monitored closely, as each is expected to bring greater diversification through their TAA approach.
But the aim is to put as few constraints as possible on the managers as to how they implement their portfolio choices. While many of the positions are taken in the traditional assets classes and currencies, commodities are part of the investment universe as well.
“Putting in restrictions is not our objective, because that negatively effects the performance objective.”
Looking forwards the goal is to see how risk within the different programmes is allocated to economic themes. “We want to understand better how changes in the economic environment will affect the performance of the portfolio. We think this further improves our insight in both the style of the managers as well as diversification between them.”
Nuijten confirms that the fee basis involved is mainly on performance. The mandates have what he terms as a performance objective. What is being sought is a high targeted return over the allocated risk budget. The information ratio, which he says varies through time, is expected to be around 0.8.
Of the experience so far, PGGM feels it is much too early to judge, with GSAM just completing the first year of the mandate. “We are very confident about all the managers that we have chosen,” he says.