Beta management keeps market risk in check

Market risk management is one of the most important issues facing European pension funds today. APK, the Austrian multi-employer pension fund, has strong convictions about the importance of market risk management.

For the fund, the maxim that market risk equals beta management is an integral part of its active global equity management process, and one of its equity return drivers.

So it has ignored what it calls the general infatuation with alpha, and has instead set up an enhanced market risk management process using equity and currency derivatives.
Such has been its success that the strategy was the subject of an article in the Wall
Street Journal Europe on 5 September this year.

It is for its achievements in using derivatives to hedge both currency and equity risk that APK has been crowned winner of the Best Derivatives category in this year's IPE Awards.

The long-equity segment of APK's €2.5bn worth of assets is a multi-manager, multi-style portfolio with 15 external managers. APK's long-term view of socio-economic developments dictates that its equity portfolio includes a high proportion of non-euro investments. Over 75% of the equity portfolio is unhedged, with 45% as US dollar risk.

The fund says that there is an obvious need for currency hedging, but that the interest rate differential makes a permanent hedge too costly.  However, the pension plan's own characteristics meant that an external currency overlay programme was not suitable either.

So over the course of many discussions, both internally and with outside bodies, the fund developed its own discretionary, structured currency management process, which incorporates hedging as well as return-generating objectives.

The fund started with a fundamental process that also considered technical patterns for setting limits on opening and closing positions. Later, it added an anti-cyclical process, to capture the overshooting phenomenon in currency markets.

On the other side, the process is completed by a momentum-based system, which is used to follow market trends. All these partial processes are discretionary so that, although every currency transaction is a guided, structured decision, it still ultimately depends on the manager's judgement.

APK uses currency forwards that it trades and actively manages with selected counterparties. It says that this is more helpful than option-based strategies, which can quite soon become complex.

The fund's experience is that the theoretical advantage of options - namely, that investors can set up option positions that precisely reflect their expectations and the associated payoff profiles - are, in practice, seldom truly exploited, because it is very difficult to arrive at a precise specification of the expected payoff profile.

All in all, over the past four years, APK's currency management process has contributed to a decrease in overall portfolio volatility, and "added" about 45 basis points in additional performance each year.

APK says that one of the benefits of this internal discretionary currency management process has been a much greater awareness of market risks within the pension fund itself, as well as comfort in using derivatives to manage these risks.

The pension fund has also developed a risk management process to deal with equity market risk (beta), since this is still the most relevant component of total equity risk.
About 50% of the fund's equity portfolio is strategically allocated to Europe, so for that the fund uses Europe's most liquid equity derivatives contract, the EuroStoxx50, traded on the Eurex derivatives exchange. For the non-Europe part, it uses the S&P 500 futures contract as a proxy.

The fund says it was aware of basis risks, but made the assumption that basis risk is less of an issue than liquidity risk.

The fund says that as always, making the actual trading decisions was the hardest part of the whole exercise. Even though avoided losses are much easier to explain than foregone profits, they still need to be limited in size. APK decided to use the year-to-date outperformance of its hedging strategy as the risk budget for the size of derivative positions.

Besides running portfolios, an important part of successful pension fund management is conveying information to the members.

In May 2007, it became increasingly obvious to APK that the investment picture was at its brightest and it was only going to be a short while before stock prices started to fall. So the fund started to convey this idea to its plan members, warning that a stock market fall was likely, and telling them it intended to use stock index futures as a protection for the portfolio.

The members therefore understood why the fund would be temporarily reducing its equity exposure, and how this would maintain performance. APK says that one of the most exciting and rewarding aspects of this communicaton process was succeeding in explaining to, say, 75-year-old plan members the purpose and methodology of futures contracts.

So starting in early June, APK reduced its equity exposure from 45% to between 25% and 30% of a typical plan's assets.

By the time the market correction happened in July and August, the fund was already hedged, and therefore able to maintain its year-to-date equity performance. The return was around 10% for the year to June and is still at that level, compared with the equity benchmark's return of 0%.


For APK, protection against market risk is most effective if it manages beta, not alpha. With this in mind, APK has successfully enhanced its market risk management process using equity and currency derivatives. For the currency hedging, it has set up fundamental and anti-cyclical processes, balanced by a momentum-based system following market trends. Trades in currency forwards are carried out on a discretionary basis. This hedge has reduced volatility and added 45bp a year to return.

APK manages equity market risk by using stock index futures — EuroStoxx50 contracts for the European part of the portfolio, and S&P 500 futures for the rest. By reducing its equity exposure in early June, APK was able to maintain the year-to-date return of 10% throughout the stock market correction. Furthermore, full communication with scheme members ensured they understood why the fund had taken these radical steps.

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