Dealing with the ups and downs
How do you address volatility?
Pension fund manager
Royal County of Berkshire Pension Fund
• Invested assets: £1.4bn (€1.6bn)
• Members: 50,000
• DB scheme
• Date established: 1928
• Funding level: estimated 82% (August 2011)
The recent volatility in equity markets has been reflected in the reduction in the value of our assets. But this has not led to a change of our strategies or asset allocation, as we believe we are already widely diversified. In fact, we believe that the volatility of our investment returns is considerably lower than those of most other local government pension funds.
At present we do not try to control volatility in equities and other asset classes through the use of derivative overlays, hedge options or insurance but we are looking at cost-effective ways of doing so.
But our broadly diversified portfolio has performed well in the recent market turmoil.
We changed our strategic asset allocation through 2009 precisely to reduce volatility in our portfolio while maintaining equity-type returns. This involved cutting long-only equities from 70% to 22.5% and replacing them with other asset classes such as private equity, commodities, hedge funds, indirect global property, infrastructure, high yield and emerging market bonds. This led to a much higher allocation to fixed income and alternatives versus equities.
As a result we are now invested in private and listed equities with 34%, 17.5% in absolute return strategies, 11.2% in bonds, 11.6% in convertible bonds and 6.9% in real estate with. Our alternatives exposure consists of 10.6% in commodities and 3.2% in infrastructure. Around 5% are kept in cash.
In addition to that, we have hedged our longevity risk - in other words, 11,000 retired council workers now have their pensions insured with a Swiss insurer.
The pension fund also established an investment working group in 2009, which reacts quickly to market risks and opportunities, allowing us to deal with volatility better.
We have had virtually no exposure to sovereign bonds for some time and had no exposure to Portuguese, Irish, Italian, Greek and Spanish or any other European government bonds. Indeed, during the year we have reduced exposure to both high yield and investment grade corporate bonds, as we considered credit spreads had tightened too far given mounting economic uncertainty.
Our exposure to infrastructure, private equity and real estate will grow in the future as managers draw down committed capital, which is currently held in convertible bonds. We may also allocate more to equities and/or absolute return funds.
Head of asset management
• Invested assets: €55bn
• Members: 1.5m
• Hybrid: DC with guaranteed minimum interest return
• Date established: 1995
• Funding level: between 102-109%, depending on the individual scheme
Falling equity markets and the resultant increase in volatility in recent months has obviously led to losses in our long-only equity positions, which has slightly reduced our risk budget. However, this year and last we have issued mandates that benefit from volatility.
We have been running managed futures strategies in hedge funds, such as commodities hedge funds, which tend to profit from high volatility, but have put an emphasis on currencies too. We also added volatility-driven absolute return strategies, which performed well in recent months.
We started investing in hedge fund of funds in 2005. But following our initial experiences, particularly during the financial crisis when correlations between asset classes were very high, we started to expand our managed futures strategies that served us so well in 2008.
We also run strategies in fixed income that benefit from volatility. We invest in structured products such as steepeners with long volatility. We initially completed those in 2006 and 2007 but due to the rising volatility in the fixed income markets we restructured some of these bonds and were therefore able to lock in higher fixed interest. The remaining positions have enabled us to benefit from the recent volatility.
At present we do not make use of overlay management. But our investment portfolio contains large elements of tactical asset allocation, which automatically shifts from equities to bonds in times of flagging equity markets and therefore protects our risk budget.
We are also boosting our investments in asset classes that have a low correlation to equity and bond markets, such as infrastructure, timber, real estate and renewable energy.
Despite the recent volatility, BVK's securities lending programme in equities is still running. It was suspended in 2008 but taken up again in 2010.
BVK has never heavily invested in government bonds. The current sovereign bond exposure stands at 1% of the overall portfolio, which is why the downgrading of some of the euro markets has hardly affected us.
Several other German pension funds have some segments of our asset allocation. But many also have overlay mandates these days, which - due to their stop loss orders - can reinforce short-term market volatility.
• Invested assets: €1.2bn
• Members: 12,000, of which only 670 are active
• Collective defined contribution
• Date established: 1971
• Solvency ratio: 109% (August 2011)
While the volatility of recent months has affected us negatively, its effects have been limited due to the hedging we have in place.
In the summer of 2010 we started to hedge 75% of our listed equity exposure with put options. We decided on this hedge based on the stress calculations we made together with our strategic risk manager Cardano. The main focus of those was to maintain a solvency ratio of over 100%, as we cannot afford to have a coverage ratio below 100% and still pay out €70m net in pensions every year.
We last cut our exposure to listed equities from 25% of the overall fund to 20% in 2009 and have maintained that allocation. But with the 75% hedge through put options, we are effectively cutting our exposure to equities further.
We have also hedged our interest rate risks. Half of our liabilities are hedged with a cash flow match and 25% with swaptions, the latter of which was hedged with swaps until the summer of 2010. At the time we had the outlook that due to inflationary pressures interest rates would rise. As swaptions initially do not form as good a hedge as swaps we have been hurt slightly more by the decline in interest rates.
The downgradings and worries in the sovereign bond markets have had a limited affect on us. We had already sold our Greek bond exposure at the beginning of the crisis in December 2009. Irish bonds were sold at the beginning of this year, while we sold most of our Spanish allocation during this summer. The capital from the sale of those bonds was allocated to Dutch and German government bonds.
We recently even started to look at France in order to potentially decrease our exposure there, especially at the long end of the curve. We are still holding onto our Italian government bond allocation - we think it is more beneficial to look at France where the spreads are still relatively narrow and it does not cost us as much money to sell them. French government bonds also present the bigger risk as the crisis in the euro-zone spreads.
Other Dutch pension funds use partly the same measures as us to curb volatility. However, few other schemes are as mature as our fund, and can therefore handle any volatility better. However, we are already paying the pensions from our equity portfolio, which is why we will be looking at more low-volatility strategies in our equity portfolio.