Nina Röhrbein spoke with Gregor Hirt, head of investment for the pension fund Vorsorgestiftung Schroder & Co Bank, who explains how it punches above its weight
In boxing, public attention often focuses on the heavyweight fighters. In pensions this is no different.
But sometimes a smaller contestant or pension fund, like Swiss Vorsorgestiftung Schroder & Co Bank, punches above its weight, scooping the Best Pension Fund in Switzerland Award at the IPE Awards in November 2011.
In 2006, the pension fund decided to move away from a traditional benchmark approach to a more dynamic and risk-oriented strategy, targeting absolute returns. Due to its active management it was able to put in place downside protection and so avoid large benchmark-driven downside corrections. Not only did this work well in 2008 and 2010, but over the past six years the overall volatility and downside of the fund has been lower than that of the common benchmarks used by Swiss pension funds.
“Most pension funds in Switzerland are still benchmark-oriented,” says Gregor Hirt, head of investment for the pension fund Vorsorgestiftung Schroder & Co Bank. “However, to many corporate pension funds, our asymmetric approach has been a welcome alternative to the traditional benchmark-driven mindset.”
In the past, the pension fund, like many of its Swiss counterparts, used the LPP 40 index as a benchmark which, together with LPP 25 and LPP 60, is one of the most commonly used Pictet indices.
However, due to the large tracking error between these volatile benchmarks and the stable underlying liabilities, this index was far from ideal.
“Most ALM studies recommend capitalisation weighted benchmarks, especially on the bond side,” says Hirt. “But it is sub-optimal to recommend lending the largest amount of money to companies and states which are the most indebted. In your private life you would never lend a lot of money to a friend playing in the casino, so why would you do it in your pension fund? Another reason is that short-term corrections can put long-term objectives at risk, as moving into underfunding will lead to a forced de-risking of the portfolio, usually at the worst moment of the cycle.”
Schroders manages two mandates for the pension fund: the BVG-Stiftung, a mandatory foundation that, in accordance with Swiss law is required to generate the annual minimum return set by the government, and the defined contribution Vorsorgestiftung portfolio, which has mandatory membership. If the minimum performance is not generated by the BVG-Stiftung, it will be compensated for by a transfer payment from the Vorsorgestiftung. Staff close to retirement can allocate part of their capital to a 100% cash fund.
Although the Vorsorgestiftung has been around since 1985, it only has 200 members, all employees of Schroders Switzerland. The employer makes the biggest contribution to the pension fund of 15%, while employees contribute a minimum 5% of their salary. When they retire, employees and their capital are transferred into an insurance plan.
The overall objective of the Vorsorgestiftung is to be able to cover present and future liabilities at all times.
“We believe that the best way to achieve this is by having a dynamic asset allocation which aims to outperform an absolute-return target over a normal financial cycle,” says Hirt. “Our current target is LIBOR-plus 2% per year, and we favour asymmetric types of returns. We control the risk by fixing a maximum ex-ante value-at-risk (VaR) for the portfolio. Our current VaR at a 95% confidence level should not exceed 5% over a rolling one-year period. The level of ex-ante risk allowed will be closely related to the pension fund’s reserves in order to avoid underfunding.”
Besides the limit on VaR, which is decided by the pension fund board, the pension fund also follows other risk measures, such as CVaR and maximum drawdown. It also analyses the factor risk within the pension fund’s assets and stress-tests its allocation based on its in-house tools.
The risk budget and return target are achieved via active asset allocation throughout the economic cycle, a focus on the risk premium instead of asset class forecasts and an emphasis on risk management at the overall portfolio level rather than separately per asset class.
As the fund makes use of Schroders’ global multi-asset resources and internally developed risk and optimisation tools, asset allocation decisions are taken in-house. When it comes to the choice of investment instruments, the pension fund selects the most suitable tool, be it direct or indirect, internal or external, active or passive. The pension fund’s dynamic asset allocation is based on the multi-asset team’s research into risk premia such as credit, equity, term and emerging markets. Risk premia tend to exhibit much lower correlations with one another than is the case with asset classes, according to Hirt, especially in times of stress.
“We complete the process with a range of short-term, high-conviction tactical trades which will be more opportunistic in nature,” adds Hirt. “We do not preclude any asset class but are very selective when it comes to the underlying instruments - cost, liquidity and the ability to integrate the instrument into our risk management systems are critical.”
To discuss short-term ideas, the pension fund has a global, beta-oriented asset allocation committee of six, which meets monthly.
“One of our strengths as a pure asset manager is that we can implement our decisions quickly by taking decisions in a committee consisting of fund managers,” says Hirt. “However, as the committee contains people from London, New York, Hong Kong and Switzerland, a lot of the discussed ideas are not relevant. We, for example, still have to have a large allocation to Swiss bonds, Swiss equity and real estate, which is why we have a meeting directly afterwards where we discuss ideas that are specific to the Swiss market. This flexibility and dynamic approach allows us to change our positions quickly, which is vital when you have an active asset allocation process.”
As a result of its dynamic and cyclical approach, the range of the pension fund’s asset allocation is broad and reviewed on a daily basis. Investments in bonds, for example, can range from 20% to 80%. The liquidity position can vary between 0-50%, shares between 0-50%, alternatives between 0-15% and real estate between 0-30%.
At the beginning of 2009, for example, the pension fund started to increase its high yield investments, building the position over 18 months before reducing it again to zero in June 2011.
Hirt says: “We mainly have a buy-and-hold strategy for Swiss bonds because the trading in and out of Swiss bonds will result in a tax disadvantage, especially at this interest rate level. Of course, we can have an overlay with futures to adjust our duration. Liquidity is important to us - one of the strengths we had in 2008 was that we had started to sell part of the illiquid portfolio back in 2007 when there was still a healthy market for these positions.”
In 2006, the fund stopped buying private equity, leaving it only with a small position today. The pension fund is a huge fan of infrastructure because, according to Hirt, the asset class is quite predictable in terms of dividend flows due to the long-term projects in which it invests.
With regard to other alternatives, the Vorsorgestiftung has one position in insurance-linked securities, which registered a positive performance in 2008. “We can also buy commodities through Schroders funds or optimised exchange-traded funds (ETFs) that will position themselves throughout the curve,” says Hirt. “What we cannot do for legal reasons is, for example, buy only a future on oil because, according to Swiss law, we have to buy a diversified type of product.”
At present, the Vorsorgestiftung has allocated around 30% to Swiss bonds. It increased its allocation to foreign bonds to around 20% after not having had any exposure to foreign bonds at various stages during 2011 when it preferred Swiss paper - widely regarded as a safe haven. At present, with 10-year Swiss bonds below 1%, they have become less interesting for the fund, which is why the Vorsorgestiftung has started to increase its position in corporate bonds, particularly in the US but also Europe.
“Big corporations have much more solid cashflows than the structurally inefficient bonds of some governments and this time around they have been more cautious with their money,” says Hirt.
While the Swiss regulator has put a limit of 50% on the exposure to equities for pension funds, there are no restrictions on the bond side, as long as the overall foreign currency exposure stays below 30%.
The pension fund invests where it believes there is added value, or the region which best fits its convictions. In other words, it does not have a fixed allocation to European or global equity. At some points in 2011, it had no investments in euro-zone equities at all. Instead, it had a few investments in Swiss equities, a large exposure to UK equities and an even bigger allocation to US equities.
“Most Swiss pension funds tend to follow the MSCI World index with regard to their allocation,” says Hirt. “In our case, if there is more potential in US equities on an unhedged basis versus European equities, then we buy US equities. The same applies to emerging markets although in that asset class liquidity issues also come into play.”
While large Swiss pension funds tend to invest in Swiss real estate directly, the Vorsorgestiftung - like other smaller pension funds - can invest in so-called Anlagestiftungen, which are tax-free instruments for pension funds.
It has remained invested in Swiss real estate over the past four years but is now looking at attractive opportunities in Europe. Its preferred structure for property investments is a fund of direct investments.
The pension fund treats currency as an active asset class. Because of its Swiss liabilities, according to Hirt, the natural position of a Swiss pension fund is to be almost fully hedged before some tactical bets are taken.
“At the moment, for portfolio construction reasons our favourite foreign currency is the US dollar,” he says. “The US dollar has proven quite resilient when large corrections happen, which is why having a 5-7% allocation to the US dollar makes sense. However, in the long term we still think that most major currencies will weaken against the Swiss franc.”