The Dutch have a saying that “the sun goes up for nothing”. In other words everything else has a price.
Dutch pension funds that have had their fingers badly burned in the equity bear market are now demanding equity style returns without equity risk. How are asset managers responding to this demand? Which products are selling in the new risk-averse but yield-hungry environment?
The greatest demand last year was for higher yielding fixed income products, say asset managers. Obbe Kok, head of institutional clients at ING Investment Management, comments: “Last year the most successful. products we have been able to put into the market have been emerging market debt and our high yield fund range, both the global high yield and US high yield products we have. The reason for that is that pension funds either had a new tactical allocation or even a strategic allocation to those asset classes.”
Products which square the circle – high returns and low volatility – have also been popular. Aegon Asset Management has developed a product for pension funds called Total Pensions Solutions. It developed this in-house, using the assets of Aegon’s own pension fund. Now it is rolling it out for public use.
Total Pensions Solutions provides a wide diversification of asset classes, from fixed income – including credits, high yield, and asset backed securities – to equities, hedge funds private equity and commodities. “By managing this mix we can to construct portfolios with just a touch higher expected returns and much lower volatility,” says Frans van der Horst, head of acquisition and client servicing at Aegon AM,
Aegon is offering the product initially to defined benefit (DB) schemes , but is also scaling down the concept for defined contribution (DC) schemes.
A strategy for leveraging equity returns while protecting against downside risk is also attracting interest from pension funds, says Cees Dert, global head of structured asset management ABN Amro Asset Management.
“Many pension funds are having to increase their allocation to fixed income, and will move from say a 50:50 fixed income/equities split to 70:30. That will reduce the risk of under funding but will also reduce the expected return on the assets – and the potential to index benefit payments.
“The question is how does a pension fund keep the expected return on its assets high enough to match the growth of indexed liabilities?”
The remaining 30% might, in a traditional asset mix, be invested straightforwardly in equities. However, this strategy can be refined by diversification, he suggests, with exposure not only to equities but also to credit risk or – if the markets allow - insurance type investments like catastrophe bonds or weather derivatives or whatever.
“The essence of it is that one looks for an asset class that provides a risk premium but is lowly correlated.”
A further refinement is to leverage the investment in risk assets. “The idea here is that instead of having one euro invested in, say, a traditional risky asset such as equities, one could choose to invest only 30 cents with equities exposure - but much more aggressively, say with a leverage of three - and 70 cents in a safe asset. This would keep the expected return at the desired high level but it would also reduce the risk of large losses.”
Which leverage tool is used will depend on the asset class. Equities would normally be leveraged with derivatives. However, ABN Amro AM uses a derivatives mutual fund. “ A pension fund that buys this will have no derivatives exposure on its balance sheet. It would simply have shares in an open-ended mutual fund which it leaves at any time. In this way the fund can invest 70 cents in a safe assets and 30 cents in the derivatives mutual fund as a way of getting exposure to international equities.”
Historically the annual return of the ABN Amro AM derivatives fund averages about three times the return of the MSCI World equity index. “We are seeing much more interest in these structures now,” says Dert.
Asset managers are also selling products to pension funds that have chosen to move to reinsured contracts. Peter in de Rijp, executive director institutional at Fortis Investments, says pension funds are currently adding more diversified asset management products to insurance contracts “Pension funds are demanding room within the insurance contract to have a stake in various asset management products.”
Fortis Investment’s most successful product for this purpose is its Fortis OBAM, a retail fund listed in Amsterdam. “This has shown a tremendously good performance last year and we are seeing now really new money flowing in from pension funds,” says in de Rijp. “Although it’s a retail fund, because of its track record and its consistency, it is used by pension funds who are not that worried about tracking error.
“Pension funds also use it in a core-satellite approach whereby they have the core managed passively and they want a bit more of a global equity tracking error product in the satellite.”
Another product which offers pension funds a way of re-building their balance sheet is subordinated debt. ING IM , together with ING Bank, is currently developing a vehicle which enables pension funds to attract subordinated debt in the market. ING IM’s Kok explains: “It’s a structure very similar to an asset backed security, where we can help pension funds get subordinated debt out of the market that is financed by third parties and not by their sponsor.
“It helps pension funds to improve their solvency, which effectively helps them to keep the equity stake at the current level and therefore improving their power to recover from the present situation of under-funding.”
Kok says ING IM is currently talking to five pension funds about the product. “This is something new for the Dutch market and purely structured for the Dutch market but it could be extended to other markets as well.”
One drawback of the strategy is that structured products make money for banks rather than asset managers. “Although we have developed this within ING IM in the end we will not earn a penny on the product. But we think it is important to develop products like this with our clients because they will help them to become stronger in the current situation.”
Overall, there may have been a shift in the focus of asset managers from the hard-nosed selling of pension fund products to the longer-term provision of advisory services. Henk Bruink, country manager at F& C Netherlands, senses that there has been a broad change in the way asset managers approach their clients and potential clients.
“I think there a change in the role that we take. The experience of the last few years has taught us that it isn’t good enough for us to focus on the asset-only aspects of benchmarks. If anything – and we believe that is also the direction that the boards of pension funds are moving in their thinking - we believe that the industry in the Netherlands is back to the point where we are focusing more on what really the core question is for the pension fund - which is basically no more or no less than to meet the liabilities of the members.
“That means that we as asset managers must be able to think away from just product delivery and more towards service delivery.
This will also mean a more proactive, less reactive stance. “We can’t afford to just sit there and wait until the occasional RFP comes by and then pitch with the product. Obviously we will continue to respond and participate in these processes as and when they happen, but we believe the more effective way is to ask pension fund clients to open up to us in terms of what they believe the overall issues are that confront their fund.
“Then we can see if we can help in terms of presenting pension fund boards with scenarios about how the future might look.”