Silvio Vecchi, CEO and CIO of the European Patent Office’s pension scheme, tells David White of the importance of patience and time in avoiding the turbulence of the capital markets - a successful strategy given the fund’s growth
Silvio Vecchi, the man who runs the €3.4bn reserve fund for the European Patent Office’s pension scheme, likes to cite Tolstoy’s dictum that “the strongest of all warriors are these two: patience and time”.
In the 10 years since he took over the administration of the fund, Vecchi, who combines the roles of CEO and CIO, has pursued what he describes as a ‘modest’ investment strategy, based on the belief that capital markets are highly efficient and that a consistent approach to investment will pay off in the long run.
“We are aware there is some inefficiency in the markets, which gives some room for a skilled active manager to take some bets,” he says. “But we are also aware of the limited extent of these possibilities. That is why we do not try to make big bets.”
Recalling an analogy mentioned by Charles Ellis in one of his books, Vecchi compares the reserve fund’s investment strategy with the navigation of a jet aircraft. “A modern airliner has the capability to fly through turbulence without damage provided the pilot does not make too rash moves. Our philosophy is that if you limit your bets and if you try to pursue the same, well proven, strategy, even in adverse market conditions, you will achieve good results in the long term.”
Even in the medium term, the results have been impressive. Over 10 years, the fund’s annual returns have been 7.4% against a benchmark of 6.7% and a long term actuarial objective of 5.2%.
As a result, the fund’s assets have grown from €1.2bn in 1997 to €3.4bn in 2006, providing a healthy reserve for future pensions provision for employees of the European Patent Office (EPO).
The EPO was established 30 years ago to improve co-operation on the protection of inventions within Europe. Its head office is in Munich, with a second office in The Hague, and two sub-offices in Vienna and Berlin. The EPO is now the second largest European organisation with nearly 6,500 employees from 32 nations at five sites in four countries.
All employees are covered by the EPO’s defined benefit (DB) pension scheme. The Reserve Funds for Pensions and Social Security (RFPSS) supports the pension scheme by providing the necessary reserves. The RFPSS was originally intended only as reserve for basic pensions, but since 2001 it has also provided a reserve for long-term care.
Since the RFPSS’s inception, an in-house team rather than external managers have been responsible for the management of its investments. “One of the philosophies is that with an internal management team, the interest of the team is absolutely aligned with the interests of the reserve fund,” says Vecchi. “When you have an external manager there is possibly the risk of some discrepancy in terms of your long-term interest.”
The management of the fund’s portfolio is divided between three managers - one responsible for fixed income, another for domestic equities and real estate, and another for foreign equities (both developed and emerging markets) and commodities.
Keeping the investment management team small helps to keep costs down, says Vecchi. The total size of the RFPSS team, including the three portfolio managers and Vecchi, is still only 14 - barely double the complement in 1997.
“Having only three portfolio managers brings our costs to a competitive six basis points vis-a-vis assets under management,” he says.
The RFPSS also keeps the costs of external investment management down by investing indirectly rather than directly, in mutual rather than segregated funds. It uses what Vecchi describes as a form of ‘open architecture’, with investment funds run by above 30 external managers.
“We need to make the most efficient use of external management,” Vecchi explains. “So in the case of our foreign equities investments, both developed and emerging markets, the largest part of our investments is made through investment funds, which are selected by the portfolio manager responsible.”
The basic structure of the portfolio was determined in 1997, with a strategic asset allocation (SAA) of 60% to equities and 40% to bonds. This allocation has remained broadly unchanged, says Vecchi. “The equities portfolio is divided into three major asset classes - domestic equities, which for us since 1998 has meant the euro-zone, foreign equities and emerging markets.
“The proportions of these have not changed dramatically, although there has been a slight increase in emerging markets.”
The allocation to fixed income has reduced from 40% to slightly less than 30%. “The strategic allocation is still to government bonds, but we have tried to diversify into other investments this year. The results have been very good over the past year but not so good in the past few months, for obvious reasons.”
The fund is benchmarked against MSCI for equities, EFFAS for fixed income, EPRA index for real estate and S&P GSCI for commodities. There are funding restrictions. It cannot invest in bonds rated less than single A, and equity investments must be MSCI listed, investment funds must be compliant with UCITS directives or other similar criteria.
Two most significant changes to the SAA in recent years have been a 9% allocation to real estate in the 2004 SAA and a 5% allocation to commodities in the 2006 SAA (see charts 1 and 2).
“The two ALM studies indicated the opportunity for diversifying into more classical alternative investments - real estate and commodities,” says Vecchi. “The reason, particularly for commodities, was to have a proper diversifier of risk. Commodities represent an important element of diversification and reduction of the overall volatility and long-term risk for the RFPSS.”
The current strategic allocations are 8% to real estate and 5% to commodities. Both are being made indirectly through investment funds or certificates.
With this move, the RPFSS has returned to investment in real estate, but this time through indirect rather than direct investment. When the fund moved into equities in the late 1990s it ended any direct investments in real estate, including the premises of the Office.
Indirect investment in property gives the fund more flexibility than direct investment, Vecchi says. “With this kind of approach we are much freer to change investments. If we are not happy with the performance of one of our holdings we can get rid of it fairly quickly. This would not be the case if we were directly invested. We can also spread the risk because with this kind of investments we are invested all over Europe.
Commodities investment is also indirect, chiefly through investment funds. “Our resources are rather limited so we have to try to get as much result as possible with the limited resources we have,” says Vecchi. “Commodities investment is also an area where we are rather new, so we want to acquire some more experience.”
Further alternative investments have been ruled out, at least for the time being. The RFPSS supervisory board, which sets the investment guidelines, including the asset classes in which the fund is allowed to invest, has decided against investing in hedge funds and private equity.
“We did consider other alternative investments, and the initial asset allocation to alternatives, which was made in 2003 and reported in 2004, included hedge funds and private equity as potential asset classes,” says Vecchi. “But the supervisory board decided to exclude both hedge funds and private equity, for a while at least. The board decided on a more conservative course, which was to invest in real estate and later on to move to commodities.”
Yet investment in hedge funds and private equity is not unlikely in the future, Vecchi says. “If there are no exceptional circumstances the next ALM study will take place in 2010, and by that time it will be possible.”
One area of alternative investment that has attracted the supervisory board’s attention is infrastructure, says Vecchi. “The board investigated the possibility of investing in infrastructure as another alternative asset class, although it did not consider it to be suitable for the time being.”
Yet it is a strong possibility for the next strategic asset allocation, he says. “I consider this could be one of the next asset classes we will invest in 2010, we could have private equity, hedge funds and infrastructure in addition to the present fund.”
As a strong believer in efficient markets, Vecchi has no appetite for tactical asset allocation, at least in the form of market timing. “We consider this is dangerous, because it delivers results which are not consistent over time with a significant increase in risk,” he says. “We think a much more effective way of achieving our long-term results is the periodical rebalancing at the end of each quarter.”
The fund also strictly rations its use of derivatives, he says. “We use them to a limited extent and, according to our investment guidelines, with the purpose of managing risk. But if you are a long-term investor, you should not care too much about short-term volatility. In this case derivatives represent additional costs for the fund and should be used in a very cost-conscious way.”
The performance of the RFPSS has justified its investment strategy and its choice of benchmarks. Both the fund and the fund’s benchmark are well ahead of the RFPSS long-term objective of German CPI plus 3.5%, which has now been increased to 3.75%. Over 10 years, annual returns have been 7.4% against a benchmark of 6.7% and a long-term objective of 5.2%.
Performance since the beginning of 1994, when WM began measuring performance, show the fund has returned 8.4% per annum on an annualised basis against a benchmark of 6.7% and a long-term objective of 5.3%.
The fund’s information ratio has been quite good, says Vecchi. “We are in the upper quartile on a rolling five year basis and even on a 10-year basis we had a rather good information ratio.”
The five-year information ratio more than doubled between June 2003 and June 2005, increasing from 0.52% annually to 1.08% annually . This levelled out and stood at 1% annually for the period ending June 2007.
As the RFPSS has developed, so it has sought to align itself with best practice in other funds of a similar size and significance. In 2006 it contracted external consultant to look at ways of improving the regulatory framework for the RFPSS
In particular, it asked them to find ways to align it with ‘best practice’ adopted by other large and well-regarded institutional investors.
“The framework has been efficient for a long time but nevertheless with the changes in the capital market we felt it should be benchmarked vis-a-vis other similar pension funds,” says Vecchi
One of the results of the study was the proposal to establish a Statement of Investment Belief. “This is something we studied together with the supervisory board. And it has been approved.
“The statement is an official document containing what we feel to be the most relevant beliefs that should drive the strategy and the management policy of the fund.”
One area that has not been included is responsible investing. “SRI has not been included in the statement says Vecchi ” Nevertheless SRI is an area that has been discussed many times in the past, and it is an aspect that we are currently considering.”
The fund’s emphasis on diversification requires good risk management, and it has recently established an in-house risk management operation to meet this need. “It is a specialist quantitative operation team that provides risk assessment instruments and reports for the investment management group.”
Since June, market turbulence has buffeted the RFPSS, Vecchi says. Yet this turbulence is unlikely to blow the reserve fund off course, not least because its assets under management will not be needed to support the pension scheme in terms of paying out pensions for another 15 years.
“One of the positive aspects of being long-term investors is that in the troubles of the last months we are not forced to liquidate part of the portfolio.” he says. “This allows us to sit on holdings with a little less discomfort than if we had to realise some of our assets.”
Or, as Tolstoy might have said, with the protection of the two most powerful warriors - patience and time.