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Impact Investing

IPE special report May 2018


Exotic Alternatives

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APG Asset Management
Ronald Wuijster
Managing director, strategic portfolio management

• Invested assets: €173bn (end-2008)
• Fiduciary manager of several pension funds including that of the Dutch civil servants pension scheme ABP, which was founded in 1922
• Established: March 2008

Exotic beta is about systematic risks that can be linked to economic functions but are not included in the traditional CAPM model. It can be about capital formation risk transfer, the provision of liquidity, priced-in transparency or efficiency and their related premiums.

To us, exotic beta is mainly an alternative risk premium based on complexity, innovation, diversification or volatility. Alternative asset classes could also be referred to as alternative or exotic beta.

We, for example, are invested in asset classes such as intellectual property rights - music rights and pharmaceutical royalties. We also search for opportunities in insurance risks, distressed investments, catastrophe risks, currency beta, commodity backwardation and volatility strategies. Some of these investments we undertake through our innovation fund, which makes up 2% of our total portfolio, in other words we try to take advantage of the innovation premium.

Being a long-term investor gives us a competitive edge over some other investors and enables us more to reap any potential premium.

We have been investing in exotic beta since the end of 2006. The financial crisis has not impacted the weighting of these allocations; if anything, we have only increased the search for exotic risk premiums. Instead, the crisis has emphasised the need to become more innovative and creative in finding risk premium because most investors had similar portfolios and consequently became vulnerable to overriding market sentiment factors.

However, isolating the risk premium is difficult. In order to do that you have to do some additional work and be good in the structuring process, as the premium often does not come in a pre-packaged solution. For our music catalogue exposure, for example, we had to undertake some legal and accounting structuring ourselves and had to find a skilled manager to manage it. Sometimes you also have to combine it with a full investment. We look for distressed investments, for instance, in a lot of asset classes, as a distressed premium often tends to be attached only to an equity, fixed income or private equity exposure.

Problems with exotic beta investments are the execution of the investment and the general investability of the asset class, particularly the liquidity. Trying to find a skilled manager is also difficult. Pension funds investing in exotic beta need to have the skills and expertise to be able to isolate the premiums and to structure the deals themselves, as few packaged solutions are offered yet and are expensive.

Erik Valtonen
• Invested assets: SEK181bn (€17.3bn, end-2008)
• Third Swedish national pension buffer fund
• Established: 2001

We do not use the term exotic beta at AP3 - for us it is just a marketing label. Instead we prefer to talk about new strategies, which for us implies a slightly broader concept. It is anything that falls outside the traditional asset classes and risk categories, and outside the traditional portfolio structure.

We launched our new strategies portfolio a year ago. On the exotic side, it contains exposure to agriculture and a small allocation to re-insurance risk. But the portfolio also contains elements of traditional risk classes such as equity or credit risk through senior bank loans and life science equities.

We had been gradually building up the allocations as part of our attrempt to build a well-diversified portfolio but only made the explicit commitment to the new strategies as an individual structure in 2008.

The target allocation to that portfolio is 5% but we are not there yet because, in the aftermath of the financial crisis, the pace of development has slowed down. We are focusing more on our core activities such as the overall allocation process rather than pursuing new ideas although the long-term objective has remained the same.

These types of investments are typically illiquid but pension funds can sit on these assets long-term, so poor liquidity is not often a problem. However, what is unfortunate is that when a crisis hits, seemingly unrelated illiquid instruments are affected because other investors might be exiting those and pushing prices lower. Because of this increase in risk aversion the short-term diversification is less than you would hope for.

We chose the particular components of the new strategies portfolio based on an analysis of the asset class or strategy - whether it fits into our portfolio, what the expected return is, how it correlates with our existing portfolio and what it adds. In addition, we take a look at our organisation, in other words we ask ourselves whether we have the expertise and the internal resources to manage the investment. There are always going to be interesting investments, which we are not going to do because we lack the resources or skills to do it. We cannot spread our resources on all possible asset classes - we have to focus on those that we understand well and that make sense in the portfolio.

We invest in the assets of the new strategies portfolio both through funds, such as bank loans, or directly, such as catastrophe bonds.

Risks and returns vary from case to case in the portfolio. There are some investments that are equity-like and others that have a bond profile in terms of risk/return expectations.

Fons Lute
Managing director, alternative strategies
• Invested assets: €79bn (July 2009)
• Fiduciary manager of several Dutch pension funds
• Established: March 2008

To us, exotic betas are constellations of risk and return, which are not straightforward and not easily obtainable in the financial markets. They are mostly in private structures or in not too obvious public parts of the market.

There are four things we have in mind when we think of exotic beta:

First, there will always be barriers of entry to invest, distinguishing it from other asset classes.

Second, this means you have to acquire a lot of knowledge about the products before you can invest in them. This knowledge is two-fold: you have to be able to figure out how it fits into your portfolio from a strategic point of view on a macro level, but also understand what it does to the correlations as well as to risk and return. And you have to know how it works from a bottom-up perspective. If you are interested in catastrophe bonds, for example, you need to know how they are structured and how their managers handle them.

Third, size matters. We believe that exotic beta can only be achieved with a certain amount of assets under management because they are mostly offered in bigger chunks and because the expenses of the specialists that manage such assets need to be covered. And fourth, a willingness to innovate and to think outside the box is crucial on the part of the investor.

PGGM invests in infrastructure, structured credit, hedge funds, intellectual property, catastrophe bonds, real assets such as timber, special funds in agriculture, microfinance and private equity in emerging markets, all of which can deliver exotic beta. We started most of our exotic beta investments in 2002 but added microfinance and catastrophe bonds in 2008 and 2004 respectively.

It is one of our requirements that we have the specialists for the respective asset class in-house. We do not want to rely on external specialists; we want to monitor whether the exotic feature becomes reality. Most of our exposure to exotic beta is gained via funds we select ourselves. We also have an internally managed structured credit portfolio and some internally managed quant strategies, which pick up price inefficiencies in derivative and option markets.

We monitor illiquidity as a whole across the various asset classes. We determine the maximum need for liquidity that the overall portfolio may have during extreme events and macro-manage them.

Returns generally depend on the individual asset and some of them are very event-driven. Microfinance, for example, does not have the same reward structure as infrastructure or quant strategies.



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