Germany’s biggest pension provider, the multi-employer Bayerische VersorgungsKkammer, is about to become bigger. It is to add another occupational group – the psychologists – to the 12 already covered.
“This is a brand new arrangement with just 1,000 members to start with, so for reasons of economy of operations, they may decide to be included with one of our existing groups,” explains Daniel Just, CIO of the Munich-based BVK.
The BVK is pleased with how 2004 progressed. “Our overall average return was 6.7%,” he says. “But we are only showing 4.8% in the balance sheet with the rest going to hidden reserves.” With yields generally on the low side, the fund likes to keep something in reserve, he adds. Now the reserves amount to almost 10% of the fund’s assets, which stand at E32bn.
Just is a firm believer that asset allocation has to be at the heart of investment portfolios as 80 to 90% of both the return and risk comes from there. “So our asset liability management is key for us.”
With the master-fund structure the BVK adopted (see IPE January 2004) was designed to provide a “flexible common portfolio system” able to meet the requirements of all 12 funds, each with their own asset allocation.
Five master Spezialfonds were set up, run through the Universal KAG platform and with the help of global custodian BNP Paribas. The funds were: euro equity large cap, global equity large cap, equity small and mid-cap, the Euroland balanced fund and the ‘spreads’ fund – with absolute and relative return strategies.
But it was always the intention to add to these master funds, Just says. “We are now including a fund for emerging market debt and high yield, and a hedge fund to be in place at the end of May.”
It is up to each of the different funds to decide how they wish to allocate assets across the range of possibilities provided. “Our aim is that they use the flexibility this one platform offers.”
Another strand in the thinking behind this structure was to help control costs.“Our evaluation is that compared with the previous structure, our costs have reduced substantially for the E3.5bn within the master fund structure.
“But perhaps the most important outcome has been on the performance side. “Prior to the move, the asset managers we had were just generalists, now we have specialists focused on their particular areas. We have, in effect, a collection of boutiques.”
So across the board, managers in the master funds structure outperformed the markets, which Just compares with underperformance within the former, which was made up of 15 Spezialfonds. “The benchmarks these managers have are more demanding than the previous ones.” The overall 2004 return was 10% within the master funds portfolio, he says. Excluding the balanced fund, the four benchmarked funds produced an average of more than 11%. And the balanced master fund with its absolute return approach provided above 6%.
The balanced fund has a number of unusual elements, such as inclusion of convertibles, which did not have a good year in 2004. “Volume wise, some E500m is allocated to this fund. This includes 50% fixed income and 50% equities and we underweight and overweight the allocations tactically. The other segments are run on a quantitative basis in order to arrive at the equity bond split. It is the overall risk adjusted return that is important here, he adds.
“So taking these results, plus the cost savings, the whole move to the new structure has proved to be very successful,” says Just.
“Our experience is that having this common platform does work for our pension schemes,” he says. The standardised and integrated reporting systems have worked well and these are being enhanced step by step with BNP Paribas. “We are improving the convertible bonds reporting, for example.” But the standardised reporting has enabled the comparisons between managers to be done fairly. “It is manageable and easy to handle, even with more asset classes,” he concludes.
“Our next step is to have risk budgeting at individual manager level in order to better manage our risks. We have not been able to do this up to now, but in the future we should be able to calculate value at risk for the whole portfolio.”
In addition, the master funds approach will give additional flexibility when changing asset managers, even though this has not been an issue up to now. “It also allows us to bring in additional income through securities lending and the commission recapture programme.”
During 2004 the fund reviewed its strategic asset allocation taking a fiver-year view. “Our minimum target return is 4%. So the first question is how do we ensure this minimum rate of return?” This is an absolute return approach, where assets have to maintain their book value. “We use asset classes, where we do not have to write down the asset value. The most important of these are the Schuldscheindarlehen, which are 10-year loans made on a buy and hold basis and the domestic real estate portfolio.” The issue here is what way are the assets to be deployed to be sure of hitting the 4% over a 100% of the portfolio.
“This varies from pension scheme to pension scheme, depending on their risk tolerance levels, but the overall picture is that with 80% of the portfolio in these two types of assets, this can be achieved, particularly when taking our hidden reserves into account.” This portfolio has an absolute return approach, with assets on a book value basis.
The 20% portion is the “surplus” portfolio designed to increase the 4% minimum return target to 5% overall. “This means that we have to obtain a return well in excess of 5% to bring the whole portfolio up to the 5% level.” Just points out that this is what the master funds concept is designed to achieve. This portfolio in on a mark-to-market basis and is optimised using the Sharpe/Tint model.
In the coming years, what the BVK wants to do is to move the composition of the actual portfolio into line with the strategic portfolio, which will be done year-by-year depending on the fund’s ability to take risk. “So one year, we may be able to do so faster than the next when we might have to take smaller steps.”
In addition to the assets in the master funds structure, the surplus portfolio includes the international real estate funds, which are not currently included within the master funds.
For example, in the case of the dentists and veterinarians scheme, which Just reckons is representative of the BVK’s approach, the strategic asset allocation resulted in the minimum return portfolio having in average 765% or so fixed income – made up of Schuldschein – and 5% domestic real estate, with the surplus portfolio having 10.7% equities, 34% fixed income, 3.35% alternatives, consisting of high yield, emerging markets and hedge funds, all within the master funds, plus 2.5% international real estate funds.
He says the aim is to reduce the minimum return portfolio portion each year. “But how thick the slices are that we can cut off each year depends on the ability to take risk.”
This current structure was established with the assistance of consultants Alpha Portfolio Advisors, which had been used previously when setting up the master funds structure. “But we aim to use more than one adviser, so for the emerging markets and manager selection, we worked with Mercer. And for the real estate fund selection, we used FERI. You get more colour that way.”
The aim of the master fund will be to increase the international focus outside Europe by starting two new segment funds – Japan and Asia ex-Japan. The EMD and high yield now stand at over E100m and hedge funds will comprise E150m. The manager chosen for EMD is Schroders and for high yield, Goldman Sachs.
“On the hedge fund side, we made a thorough analysis, looking fist at how we can include the hedge fund side into the SAA?” There is a tendency to substantially overestimate the returns of hedge funds, with survivorship and other biases coming in, and on the volatility side, skewness and curtosis have to be taken into account. “Once you have done all of this, you can include hedge funds in your portfolio optimisation. This we did before actually investing,” says Just.
“Our target return for hedge funds is not 10 or 12%, but 5% plus X, because of the tendency to overestimate the returns here. If there is to be a surprise, we like it to be a nice one.” The hedge investment fits well into the portfolio because of the diversification benefits, he adds. “We looked, of course at the cost aspects, as the management fees are significantly higher than the other asset classes.”
The process of choosing a manager, which is ongoing, BVK undertook with the help of Alpha Portfolio Advisors, following a very detailed process because of the strict regulations involved. “The whole thing is a complex transaction. We started with a long list of 160 of managers who made presentations to us here at BVK, and on the basis of that we drew up a short list and sent those a questionnaire based on the BAFin requirements.” The next step will be to interview the different managers in their offices, before finally selecting two fund of funds managers. One of these will be multi-strategy, with a low concentration on short-bias, emerging markets and event driven, while the other mandate is relative value, with a focus on equity market neutral.
“The whole process from the SAA decision right through to the selection was a lengthy but nonetheless straightforward process,” he says. “We took our time, which we had to because as the government took its time in deciding how to allow institutional investors become active in the hedge fund area.” He reckons the whole procedure will have taken eight months.
The structure that will be used will be a Luxembourg vehicle because of the 10-year plus experience there in operating hedge funds. “But we will use our custodian BNP Paribas and the master KAG structure run by Universal. A separate master fund for the hedge investment is being set up.”
The other area being addressed is that of real estate, which has been a traditional feature of the BVK’s portfolio. “But in the last five years, the approach we have adopted to running the portfolio has changed dramatically,” says Just. The overall portfolio is E2.6bn, of which E1.1bn is in the office sector, E1.2bn is residential, with the balanced being made up of mixed utilisations.
“Five years ago 85% was in residential and we have shifted to offices, all domestic exposure in Munich, Frankfurt, Berlin, Dusseldorf, Hamburg, Stuttgart and Cologne.”
The fund switched from a buy and hold strategy to an active approach in 2000, he says. “We installed an EDP-based management system to manage the real estate portfolio.” Every single property was scored from 2001. Along with that the restructuring from residential to office took place along with more diversification from Bavaria across the rest of Germany. Now the fund has been diversifying internationally using investment funds.
“The target for the real estate international funds for 2005 is over E100m.” The domestic real estate target for 2005, is E250m in new money being allocated, but this depends on the right opportunities presenting themselves.

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