Dynamic strategy seeks out the risks that are worth it
Dutch pension fund PGGM has won the best industry-wide pension fund award for its creation of an innovative portfolio of strategies used in absolute return investing. Over the years, PGGM’s own asset- liability modelling (ALM) studies have led the fund to allocate its assets increasingly to alternative investments. However, during the 2004 ALM process, PGGM took the next innovative step in the design of its strategic mix by creating the ‘Portfolio of Strategies’. The pension fund did this because it no longer wanted to constrain itself by exclusively considering generic asset classes. It recognised that investment return is a reward for taking risk, but that not all risks are necessarily rewarded. Some risks get higher rewards than others, while still other risks are not rewarded at all. Furthermore, some kinds of risk might be more suitable than others for PGGM.
PGGM therefore created its portfolio of strategies to include dynamic investment strategies as part of its strategic asset mix, alongside asset classes. The theory behind this is that dynamic investment strategies aim to accentuate those risks which are expected to bring rewards, while at the same time neutralising those risks for which the expected reward is not big enough.
This idea is not entirely new. Portfolio managers already use investment strategies opportunistically in tactical programmes to exploit temporary developments in financial markets. What is new is that the investment strategies in PGGM’s portfolio of strategies are directed towards capturing structural risk premia. Traditionally, the capturing of structural risk premia has been carried out by buying and holding financial assets; PGGM believes that there are other structural risk premia which cannot be captured by doing this, but by using dynamic strategies instead.
An added bonus of employing dynamic strategies is that, instead of taking what the markets provide in the form of assets, PGGM can aim for those risk premia for which it is better equipped than for others – for instance because of its size, network, liability horizon, liquidity position, balance sheet and regulatory issues.
PGGM then had to incorporate these ideas in its portfolio management. The portfolio of strategies was created as a platform to put into place dynamic investment strategies, but it does not specify what shape and form the individual strategies should take. So anything is allowed, as long as the strategies meet a set of requirements to ensure their structural character. However, although the characteristics of the individual strategies are not known beforehand, there is a clear target for the characteristics of the portfolio of strategies as a whole. Volatility should be around 7.5% annually, with a target absolute return of Euribor plus 3.7%. There should also be only a low correlation with the rest of PGGM’s strategic mix.
The most important tool to ensure meeting the targets for the portfolio of strategies is the new and innovative method of capital allocation to the portfolio of strategies. In contrast with the traditional method – where capital is allocated to a particular asset class based on a percentage of the total assets – the capital allocated to the portfolio of strategies is based on the amount of absolute risk the portfolio represents. It does not matter whether or not the strategies in the portfolio of strategies need funding, or can be leveraged. What does matter is the total risk that the portfolio represents.
Capital is transferred to, or withdrawn from, the portfolio each month to ensure that the on-balance value of the portfolio is such that each unit of risk is covered by a fixed amount of capital. Part of the capital is used to fund the strategies, with the rest put in a cash account. This method of capital allocation ensures stable volatility: whenever the risk in the portfolio increases (or decreases) this is compensated for by the allocation (or withdrawal) of extra (or excess) capital.
Traditionally, the capital is fixed and the volatility varies, but with this process it is the other way round. The fixed ratio between assets and risk is 28, which implies a volatility of 7.5%. The target return of 3.7% above Euribor is based on the prudent assumption that overall, the expected excess return is 0.5% for every per cent of volatility. So taking risk as a starting point in the capital allocation is consistent with the philosophy that return is achieved from risk, rather than capital.
PGGM started to use its portfolio of strategies process on 1 January 2005, and the returns – 6.67% for the year to date – have exceeded expectations. The pension fund says the technique has encouraged innovative thinking within its own organisation, as it demands that its managers search for opportunities over and above those which have already been considered. In taking up this search, it has also become clear that PGGM’s external network provides more value than was previously recognised.
By using the portfolio of strategies, PGGM says it has adopted the recent trend towards absolute return investing, but in a much wider context than by using the traditional hedge fund strategies with which this type of investing is normally associated.