Many people assume that German pension fund asset allocation is a conservative game. But it is famously the exceptions that prove the rule.
Accordingly, the asset allocation of Ärzte-versorgung Westfalen-Lippe (AVWL), the pension fund for doctors and their dependants in the Westfalen-Lippe area of North Rhine-Westphalia, is more broadly diversified than some would expect.
The scheme’s strategic asset allocation, which is designed to achieve a specified actuarial rate of return, invests as much as 8-10% in alternatives such as private equity, hedge funds, structured credits and commodities, 20% in real estate and in 20% mortgages.
In cooperation with a number of German Banks, AVWL provides around 17,000 of so-called 1A individual mortgages from its own balance sheet instead of investing in residential mortgage-backed securities (RMBS) or other fungible mortgage bonds. Because of its strict risk management policy, the lending is restricted to non-commercial real estate in western and northern parts of Germany, and so far the pension fund has suffered no mortgage or sub-prime related loss in its lending business. In addition, AVWL was also able to generate a stable illiquidity premium. And even in the midst of a financial crisis the returns from the mortgage business were highly positive.
The pension fund is also involved in the development of real estate projects, the majority of which are inner-city retail projects in Germany’s biggest cities such as Berlin, Düsseldorf, Frankfurt, Hamburg, Mannheim, Munich and Stuttgart.
“On top of that there are other projects we have undertaken such as the development of an office building called Kranhaus1 in the Rheinauhafen area of Cologne,” says Andreas Kretschmer, chief executive officer of AVWL. “This project even won the first prize in the business centre category at this year’s international real estate fair in Cannes.”
Direct property holdings amount to €600m of the fund’s €1.5bn real estate portfolio, while the majority consists of indirect global real estate fund investments.
The scheme also has some indirect real estate exposure in its Luxembourg institutional fund, a Fonds Commun de Placement (FCP). AVWL has invested around €600m in the fund, which also comprises allocations to private equity, derivatives, hedge funds, structured credits and commodities.
The pension fund agreed to investments in the vehicle at the end of 2006 once critical mass for each alternative asset class - then a combined total of €520m - was reached.
“We have already been investing in private equity for more than a decade,” says Kretschmer. “We decided to opt for a Luxembourg FCP rather than a Spezialfonds - the German equivalent - because, to us, it offers the highest possible amount of transparency and freedom to invest in alternatives, while still complying with German regulations. The fund structure allows a constant portfolio optimisation process to take place. And unlike our previous alternative models, it highlights where we are underweight and points out investment opportunities, while at the same time identifying investments that are no longer efficient.”
Kretschmer puts the pension fund’s relatively high alternatives exposure down to the technology bubble in the late 1990s. “When the bubble burst, we decided to move away from equities,” he explains. “As a long-term investor we wanted to take advantage of the illiquidity premium - that is why we started to invest in private equity. Up to now we have been receiving more contributions than we pay out in pension benefits and the situation is set to continue for the next few years. In other words, each year we have a relatively high liquidity surplus. This year, for example, it amounts to €860m, which allows us to invest in property developments and private equity because we do not need the earnings immediately.”
As part of its commodity investments, AVWL has invested in recommissioned salt mines in Northern Germany, where oil and gas is transported from countries such as Algeria, the Netherlands or Russia and stored as strategic energy reserves. These make up €50m of the scheme’s alternative investments. Apart from these caverns, it also has exposure to various other alternative investments, including a globally diversified €100m commodities timber fund, which forms part of the Luxembourg FCP.
“The growth in world population and the middle classes in developing countries, for example in India and China, will lead to increasing demand for commodities,” says Kretschmer. “Timber is one typical middle-class commodity because it is needed for the construction of houses and furniture. It can also compensate for economic cycles because its growth is uncorrelated to other asset classes and there is no pressing need to harvest.”
But of course the financial crisis did not pass AVWL without a trace. “Like many investors, we heavily exited equities as an asset class during the course of the last year, although the equities exposure in the underlying remained unchanged,” says Kretschmer. “We are now left with an equity allocation of only 3% compared with an allocation of 12% in early 2008. However, we may open the hedge - the derivatives - again later this year, which would automatically lead us back to a two-digit equity exposure.”
In fact, the only direct involvement in the crisis was a €30m investment in a so-called Schuldscheindarlehen - bonded loan - in Lehman Deutschland, which was replaced by the Federal Deposit Insurance Corporation (FDIC).
After selling the majority of its equities, the assets were first converted into cash via futures or put-options. “But since interest rates nosedived we have pulled the money out of these and invested it in corporate bonds,” says Kretschmer. “That is why our current exposure to fixed income is 40%, of which 4% is invested in corporate bonds. This includes corporate bonds from core businesses such as Daimler and Eon, which we practically view as having a guarantee by the state. They come with relatively high interest rates and so we expect to generate high returns over the next few years.”
Since the 2001-02 crisis, AVWL has applied a risk management strategy and overlay across all of its asset classes. But the strategies, says Kretschmer, have not all been proven to be correct during the crisis, expect that volatilities and maximum redemptions were exceeded.
“That is why we started to complement our basic, long-term risk overlays with tactical ones in the form of strict floor systems,” he says. “For this, risk capital is distributed among the different asset classes, and for each product a fixed floor is calculated. Once the respective product hits this level - the floor - an automatic reduction process of the asset class is triggered.”
It also works the other way around, meaning that once the market recovers, the scheme will increase its equities exposure again.
The pension fund currently has less than 1% of its total portfolio invested in hedge funds.
“One of the hedge fund structures we invest in is a so-called ‘Talenthotel’, which is managed according to different strategies, one of which is based on physics and neuronal insights,” says Kretschmer. “It achieved a relatively good result for a hedge fund in the capital markets of 2008 and generated a return of -7.8% in 2008 - that is why we will remain invested in 2009. We also plan to stay invested in our commodity hedge fund but will not increase our allocation to other hedge funds because we have already implemented event-driven or long-short strategies in our overlays. ”
The scheme also applies a currency overlay. But Kretschmer points out that if the fund were to sell, for example, property in the US, it would do this with direct currency protection.
AVWL manages the majority of its investments in-house and even manages the assets of the doctor’s fund of the state of Brandenburg. However, Kretschmer says that for its diversified investments it will work with other large asset managers such as Allianz Global Investors, DB Advisors and private bank Sal. Oppenheim to take advantage of their specialist expertise. “We will listen to their advice, but in the end it is still our house that makes the final decision,” adds Kretschmer.
The pension fund is on a bounty hunt for opportunities. It recently bought some properties in Germany and the UK, increasing its real estate exposure to 20%. This is not a surprise, taking into account the average return of roughly 6% in its real estate portfolio over the past five years. And Kretschmer sees plenty more sellers in the market, stressing that these transactions are done directly and not via a middleman.
However, the scheme cannot legally invest more than 25% of its portfolio in real estate. On top of that, a 35% risk quota exists that limits investments in volatile assets - such as equities and derivatives.