Angelien Kemna, CIO of €277bn Dutch pension fund manager APG, is going back to basics. “Pension fund management is not about chasing mandates. We need to ask ourselves: why exactly did we have these investments again? What is their purpose?”
The spring of 2011 has been decidedly chilly for Dutch pension funds. After 10 months, negotiations regarding a new pension deal have been frozen, pension fund investment strategy has become the subject of parliamentary debate, and bad press has further cooled public faith in the pension system. Despite all this, the daily business of paying out benefits and investing funds must go on. That is why Angelien Kemna of APG prefers to stay out of the fray. “Our job is to take good care of the pension savings of scheme participants, and that is what we focus on.”
As chief investment officer of APG Kemna takes care of some €277bn for over 4.5m people. Above all, this should be done in an orderly fashion that matches the ultimate objective of APG’s pension fund customers, which is to meet their pension obligations, says Kemna: “I am a strong proponent of bringing pension fund investments back to their original purpose.”
APG changes course: Simplification rather than innovation
After taking the helm from Roderick Munsters over a year ago, Kemna launched a programme of ‘controlled simplification’ and she will continue to steer APG back to basics. Kemna: “This ‘back to basics’ approach means you have to take a step back and ask yourself: why exactly did we have these investments again? What is their purpose? Pension fund management is not about chasing mandates. It is about looking which risk factors can contribute balanced returns relative to the liabilities.”
Over-engineered investment products tend to miss that mark, Kemna believes. “We went through a period of extreme financial innovation. It is time to stop that, and take a moment to see where performance is really coming from. Because a lot of those innovative instruments are complex and add very little value.”
So ‘controlled simplification’ means: no investing in unnecessary innovations. And instead of focusing on alpha - the expensive bits of extra return - it means first putting the basic market exposure, or beta, in order. But it also means one shouldn’t indiscriminately adopt all sorts of commercial benchmarks. “We are living in an over-engineered investment environment in which everybody applies the same benchmarks. It has been shown that this causes inefficiencies in the market. For some day traders, utilising those inefficiencies is all they ever do,” Kemna says.
“Besides, if you use these benchmarks you will end up having things in your portfolio that you could do without,” she adds. Commercial benchmarks tend to lump together risk factors that had best be explicitly distinguished. Government debt is an example, as indices gave high weightings to the troubled ‘PIGS’ countries. “When the euro debt crisis hit, pension fund investors found they had inadvertently taken on all sorts of sovereign debt risk, while their only objective had been to invest in government debt as a safe way to match the duration of their liabilities.”
There might be good reasons to seek exposure to sovereign debt, she adds. But the choice should be intentional, rather than the unintended by-product of an off-the-peg benchmark.
In the area of fixed income, APG has “far-reaching” plans to separate those risk factors, Kemna says. “This will allow us to avoid all sorts of undesirable situations, including the games that people play with benchmarks. For instance, some asset managers offering a corporate debt fund earn extra returns outside the benchmark by investing in emerging market debt. That may yield a nice performance but it mixes up credit risk with emerging market sovereign debt risk. We don’t want to mix up risk factors that interfere with each other on the block level. Keeping them separate makes for cleaner, purer investing.”
APG opts for ‘smart indexing’
While efforts to bring APG’s asset management back to basics have so far focused on fixed income, Kemna intends to extend this line of thinking to other categories, including equities and property.
“With regards to equity, again beta exposure is the most important issue,” she says. “Given our size we prefer indexing for a large part of our portfolio. But we do believe this should be done intelligently. We don’t want to unthinkingly accept an index - when you do that, you know you’ll be taken for a ride. Instead, we prefer to target specific factors - such as low volatility, momentum, value and dividend - that allow for a better way to get the required index exposure.”
In addition to intelligent indexing, on the other end of the spectrum APG is “committed to engaged, responsible shareholdership, where we invest in larger positions and really influence management of the companies involved,” says Kemna. “So on the one hand, we achieve diversification and market exposure in an efficient and low-cost manner through smart indexing while, on the other hand, we apply our fundamental analysis to a limited number of shares that we take really concentrated positions in.”
To extend the approach that started with fixed income to other investment categories, APG is presently developing proposals to be put to its pension fund clients. “This is an incremental process and we confer with our clients every step of the way,” says Kemna. “That’s why we call the process ‘controlled simplification’, with emphasis on ‘controlled’. We all went a bit overboard on the whole traditional mandate-chasing paradigm, and we are now working to extricate ourselves from that bit by bit, together with our clients.
“This is what distinguishes APG from commercial asset managers,” says Kemna. “I think we should be so bold. After all, our objective is different too: our goal is, first and foremost, to take good care of all of those pension savings that all those people entrusted us with.”
No more long-term investors
Other than commercial asset managers, pension fund investors aren’t preoccupied with beating their peers or outperforming market benchmarks: in the final analysis, the schemes’ long-term liabilities are their only real benchmark. By nature, managers such as APG are, therefore, the quintessential long-term investors. But it is getting ever harder to live up to this nature, and this worries Kemna no end.
“In reponse to the crisis, institutional investors are subjected to ever more rules and regulations, forcing them to act on short-term developments. If this continues, soon there will be no large long-term investors left in the world. And when that happens the stabilising, anti-cyclical effect they have on markets will disappear. On a global scale, this is one of the greatest risks we face today.”
Things get extra dicey when different sets of rules interact and exacerbate each other. Such is the case with currency risk, for instance. From a long-term perspective, there is little reason to hedge this risk, as foreign exchange fluctuations tend to ‘come out in the wash’ in the long run. “But in the short term there is the potential to lose money with no upside and so the supervisory framework FTK penalises pension funds quite severely if they do not hedge currency risk,” Kemna explains. “Now new, stricter rules to regulate over-the-counter derivatives will make it much more expensive to hedge currency risk using derivatives. In addition, the investment banks and brokers that pension fund managers turn to for these derivatives are forced to bolster their capital reserves to comply with Basel III - and they immediately pass on the extra costs of those regulations to their customers.”
So, on the one hand, rules and regulations force pension fund investors to hedge currency risk while, on the other hand, rules and regulations make hedging those risks unaffordable.
“This presents pension fund investors like us with very difficult choices,” Kemna warns. “Because of this, we may well be forced to significantly reduce the extent to which we invest globally. In other words, we may no longer be able to optimise diversification across global assets, which means we are forced to put pension money at more risk - not less. I get the impression that people don’t quite realise we’re at the brink of these types of decisions.”
At the start of the century, Kemna was charged with implementing Sarbanes-Oxley at ING, so she has first-hand experience with the sense and nonsense of restrictive regulation. “It’s a good way to manage operational risks, but it didn’t prevent the current crisis. If a medicine doesn’t work the first time around, should you simply take twice the dosage the second time around? I think not. It’s occasion to wonder if the cure is any good at all - and if it isn’t worse than the disease.”
Forcing long-term institutional investors to de-risk procyclically leads to adverse results, Kemna says: “As when institutional investors were forced to dump Greek sovereign debt last year. Or consider last year’s unnaturally low interest rates: these too were driven by institutional investors and inspired by regulation.”
These rules and regulations may curb short-term risks but introduce different risks via the back door. “If everybody is forced to let short-term considerations prevail, investors will all behave in the same manner and move in the same direction, and extreme market moves will be exacerbated. Many of the hits in the market that we are seeing, are resulting, in part, from people not being allowed to sit out the ride.”
Kemna hopes the cycle will be broken: “If not, we run the risk of buying a dangerous semblance of security in the short term that will cost us dearly in the long term.’