Liam Kennedy spoke with Ernst Hagen (pictured), head of asset management at Pension Fund Horeca & Catering (PH&C), which covers the Dutch hospitality sector

PH&C is a relatively rare object these days - a young defined benefit fund with a liability duration of over 21 years and a correspondingly long investment horizon.

As for its recent history, PH&C may have entered a recovery situation by the end of 2008, but Ernst Hagen, appointed head of investments in autumn of 2007, is confident the fund will be able to regain its financial position within three years rather than the now permissible five. Like other funds, PH&C was hit by the fall in interest rates, which increased its liabilities, and the simultaneous fall in equity markets. But at the end of January 2010, the coverage ratio was 110%, up from 93% at the end of 2008 although considerably below the 148% level acheived at the end of 2007.

The strategic equity weighting, however, is high by the standards of other Dutch pension funds at 50%, and has been maintained through of the crisis. With its high net cash inflows - just under €200m in 2008 (€236.1m in premium income and €36.8m in outgoings) - PH&C uses this cash cushion to operate a rebalancing strategy on a quarterly basis.

The strategic asset allocation itself is set with the help of a specialist ALM consultant. The asset management department assists by providing information and details of its own strategic thinking, but the consultant presents its findings to the board. Broadly, Hagen says, the focus is on long term beta. "We do not make any active, tactical calls because we strongly believe it is very difficult to actually outperform that way," he says.

The most recent exercise, in the autumn of 2009, was broader than usual: "This time we didn't just do a stochastic analysis, but also some deterministic scenarios - inflation, deflation or disinflation - to get more of a feeling of the tail risks of the distributions, but also to give the board more insight into what is happening in those tails," says Hagen. "That is something that a lot of people are asking - the range of opinions has widened given all the fiscal and monetary stimulation measures."

The result was to confirm the existing strategic asset mix for the long term, although Hagen admits that given the long duration of liabilities, the impact of interest rates on the coverage ratio is considerable. The fund does make use of interest rate hedging and actually moved to expand it to 40-41% in August 2008 using a swaption collar policy to increase the effectiveness of the hedge as interest rates continued to fall.

In practical terms, the asset management department looked at its asset allocation in January and February 2009 in its monthly tactical asset allocation meetings and decided to rebalance back to equities.

"Average returns have come down over ten years but somebody with an investment management background would say that is because risk premiums have sky rocketed. So if you want to take risk it is much better rewarded now than it was some time ago. And I guess that is the other side of the medal - equities are cheap because expected returns are higher. You need to control risk but risk also has an upside, a reward."

PH&C makes extensive use of active management, which makes up around 85% of the total portfolio. Nevertheless, the fund is still a critic of active management: "We have to be convinced that active management will add value before we appoint," as Hagen puts it. "I think that is one of the lessons of 2008: that you should critically look at where you go for active management and what sort of risk controls you put in place. Tracking error alone is certainly not sufficient."

Hagen also has misgivings about tracking error in fixed income investments, and will this year revisit the issue of fixed income benchmarks given their weighting towards large debt issuers: "Tracking error may be of relatively good use for equities, but within fixed income tracking error assumes a normal distribution and as much upside as downside, whereas if credits trade at 100 there is much more downside than there is upside."

He goes on to say that tracking error is typically a backward-looking statistical measure, but that an investor should look at the structure of individual securities. "For example, in the case of tier-one financials or mortgage backed securities, one has to look through and put a stress test on them. I think that is one of the lessons - that you need to look one layer deeper."

Hagen continues: "When we select a manager we drill down even deeper to see what was the cause of the alpha. Is it in line with the investment process and is it something we find convincing in the long term? Is it achieved in a risk controlled manner? Is it not a single bet that has dominated? For example, in a global equity mandate was it an off-benchmark call to emerging markets that dominated performance or not?"

So beta risk, Hagen reiterates, is more convincingly rewarded in the long term. "If, and there is a big if, alpha is low or uncorrelated with beta, it may be useful to diversify into alpha. But, then you get issues of how convincing is that alpha, and the pressure to understand and control what is happening in your portfolio is only increasing but I think rightly so. Those will be criteria set on any investment category that you may invest in, and if it is not transparent, and I cannot understand or control it, then it is not an investment we would consider."

An interesting example is that PH&C's broad market US equities are managed with a fundamental active, but low tracking error strategy while US small caps are indexed - the fund could not find an active manager with a convincing enough strategy that had not yet hit its capacity constraints. For many pension funds it is the other way around.

Continuing the theme of transparency, control and comprehension, it is worth noting that a big debate in Dutch occupational pensions recently has been around governance and operations of pension funds, especially in the area of delegation versus retention of key functions.

Last July, PH&C beefed up its internal resources with the appointment of three seasoned pension experts from the Dutch scene - Kees Koedijk, Jelle Mensonides and Dick Wenting. Koedijk is at Tilburg University while Mensonides is a former ABP man and Wenting was at the Pharmacists Pension Fund. Appointed in 2009 to a new investment advice committee, the three are joined by two representatives of the catering and hospitality sector. Meeting four times a year, they critique investment policy and make recommendations. Hagen describes their role as the sparring partner of the board.

So he is not fazed by the recommendation of the Frijns Committee for an improvement in pension fund governance. "I actually believe that the model we have already encompasses that," says Hagen. "If you were to outsource everything including the asset management department to a fiduciary manager you might have a potential conflict of interest because commercial fiduciary managers have their own commercial interest. There is another information layer between yourself and the investment portfolio."

Hagen says PH&C‘s asset management department is very close to the board, with direct access to investment managers and the custodian. The fund has increased the level of custodial services it receives from BNY Mellon, which was appointed last year.

Another area under consideration is the value of diversification and the lessons of the crisis. "Do you need 14 or 20 asset categories?" Hagen asks. "The price of a lot of asset categories is also a lot of governance and I think that when you consider the balance between the benefits of diversification from a risk return and volatility of returns perspective versus other risks, such as governance risks, that balance has shifted."

Hagen continues: "The marginal contribution of adding another asset category to optimise my risk return profile is so marginal that - given the additional governance that it requires from a board, the organisation, plus issues like liquidity or specialist knowledge that is required - that tradeoff is not favourable"

In practical terms, this means PH&C does not invest in hedge funds, due to their intransparency and is not likely to change this soon. He also says the fund has dropped plans to invest in non-listed real estate outside the Netherlands: "We asked ourselves whether we wanted to invest in that category. Does it deliver what we initially assumed in terms of low risk, safe returns."

Hagen continues: "We were already half way through a selection process, but we revisited it in our ALM study and decided not to add it. The marginal contribution was limited. These are illiquid investments and not worth adding from a governance perspective."

As for private equity, PH&C is to top up its portfolio with a cleantech allocation and is close to finalising a mandate.

PH&C is also reviewing its remuneration policy for asset managers. The fund believes performance fees can create an upside focused incentive that carries no downside penalty for poor performance: "In our direct agreements with managers we have never incorporated performance-related fees and have actually formalised that as a fund policy," comments Hagen. "Performance related fees are asymmetric - they are only for the upside and there is no punishment for the downside. Alignment of interest is fine but it should work both ways."
 

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