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Castilian discipline

In the increasingly vigorously regulated European pensions landscape and low-yielding environment, whipping pension funds into shape has become somewhat of a standard approach.

One of those pension funds in Southern Europe to introduce more stringent discipline is the pension plan of Spanish telecommunications giant Telefónica.

Its manager, Fonditel, introduced explicit governance rules in 2013 in order to bring more clarity to its operations.

The rules laid down the law on who is responsible for specific functions in the pension fund, something that had not been done before.

“It has created much more discipline compared to two years ago,” says Jaime Martinez-Gómez, CIO at Fonditel. “We believe that having a well-designed investment process with established rules is beneficial, which is why we have improved the pension fund’s governance. Of course the investment policy is not decided by Fonditel itself, but by the trustees of the fund with advice from me and the portfolio managers but in this decision tree, the governance structure states who decides what.”

But it was not the only development to take place at Fonditel in its recent history. The pension fund also decided to improve its risk management process in 2012, and the new system was implemented throughout 2013.

Apart from calculating daily value at risk (VaR) or tracking error, the pension fund has developed a risk budget framework.

This means that every portfolio it manages has a pre-defined active risk limit budget, which is split into different strategies. While the pension fund undertook daily monitoring of risk prior to the new risk management process, it did not have an explicit limit on every strategy.

“We have allocated a risk budget, for example, to the smart beta strategies of our equity portfolio,” says Martinez-Gómez. “The same applies to the active management in the Spanish equity portfolio. Every portfolio manager has a pre-defined rule so he can manage his portfolio according to this risk budget. We check compliance with the budget every month – if the portfolio is not within the limits we can reallocate the active risk into different strategies, depending on the circumstances.”

The main consumer of risk is, according to Martinez-Gómez, the dynamic risk management model.

“It is a type of risk-on/risk-off model that fundamentally changes our exposure to risky assets based on multiple factors,” he says. “In addition to our main, active risk strategy, there are other strategies that are more or less important in terms of risk. The idea is to have many different sources of return and not be dependent on simply one, two or three active strategies. In short we are increasing the breadth of our strategies.”

The asset allocation benchmark of the €3bn pension scheme is split between 35% equities, 50% fixed income and 15% alternatives.

This has not changed much since the very beginning of the Telefónica pension scheme 20 years ago. A review of the investment policy in early 2013 confirmed the suitability of Fonditel’s broader asset allocation. The return target for the Telefónica pension plan is euro-zone inflation plus 3%.

“But this target has been difficult to achieve,” admits Martinez-Gómez. “We had well exceeded the objective prior to 2008 but in that year we suffered and since then have remained below target.” Since inception, the annualised return has been 4.75%. However, this to date has neither altered the way the pension fund is managed nor its investment policy. “We try to adapt but without moving the big numbers,” explains Martinez-Gómez.

Fonditel’s equity portfolio is split into 60% Europe, 20% US and 20% global emerging markets. The weighting of Spain is included in the European equity portfolio and makes up around 5% of the 60%. This geographical split has been stable for a while and was just recently approved but Martinez-Gómez does not rule out a change in 2014, potentially adding exposure to Japan.

The fixed-income portfolio, which makes up around 50% of total assets, is split into two equal parts – a duration and a credit bucket.

The duration portfolio contains AAA or quasi-AAA government bonds. The credit portfolio holds other government bonds, such as Spanish and Italian, euro denominated investment grade and emerging market bonds. It may also include some exposure to high yield and local currency emerging market bonds.

In 2011, it was decided that the pension fund should have less exposure to Spanish government bonds and focus on credit instead. “We consequently added more emerging markets and investment grade bonds to the portfolio,” says Martinez-Gómez. “As a result, we have less exposure to Spanish fixed-income assets than the average pension fund in Spain.”

But Martinez-Gómez admits this could change again, as the investments are reviewed on an annual basis. “Every year we revise our asset allocation depending on the expected return of our assets,” he says. “In 2013, for example, we decided to be overweight equities in our pursuit of our target return.”

Fonditel started significant investments in emerging markets in 2009. Today emerging markets make up 10% of its credit portfolio. Its default investment approach is hard currency debt but its portfolio managers are allowed to allocate a maximum of half of the emerging markets exposure to local currencies, meaning hard currencies make up at least 50%.

At present the pension fund’s exposure is split equally between hard and local currencies. For hard currency investments, Fonditel tends to use passive vehicles such as exchange-traded funds (ETFs).

Its alternatives portfolio is dominated by private equity investments, which currently make up around 5.5% of the overall assets. The rest of the portfolio contains 3.5% real estate, 2.5% commodities and 1% hedge funds at present.

“But we are changing our alternatives portfolio,” says Martinez-Gómez. “As the average pension fund member is getting older, the fund is maturing, which is why we are reducing our long-term allocation to illiquid assets although we want to keep an alternative exposure of 15%. We want to focus on a more liquid portfolio instead, hence we are committing less to private equity and are increasingly moving into fewer illiquid strategies.”

The 5.5% allocation to private equity is set to gradually decrease to 3% in the next three years. The allocation to real estate is expected to remain stable.

“Instead of adding more hedge fund vehicles we are trying to increase our exposure to alternatives through what we call an alternative beta portfolio,” says Martinez-Gómez. “This alternative beta portfolio is made up of liquid and systematic strategies, for instance in the volatility or commodities curve, which try to harvest a risk premium. This should generate higher returns in comparison with the traditional assets in the current low yield environment, especially as we are aware of the fact that equity returns cannot continue their good run forever.”

Typically, Fonditel’s investments in alternatives take place through funds, both in private equity and in real estate but there are some exceptions, such as one direct investment in a real estate company.

The overall investment style is a mixture of passive and active. “We believe that we can improve returns relative to a buy-and-hold strategy so we are active in that sense,” says Martinez-Gómez. “However, we tend to be passive with regard to the investment vehicle we use, especially in equities because after costs it is extremely difficult to consistently beat the market in equities. In that portfolio, we use either derivatives, tracker funds or ETFs.

“Our only direct equity investments are Spanish equities where we believe we have an edge as local investors, with an in-depth knowledge of the market. Our fixed-income strategy is similar. We tend to have a passive approach once we have decided upon the asset allocation. The exceptions to this are high yield, emerging market local currency bonds and special niche assets in fixed income for which we have active mandates.”

But alternatives aside, only 4-5% of the 85% traditional portfolio is managed actively by external managers, the rest is invested passively or in-house.

A sea-change is also taking place in Fonditel’s approach to environmental, social and governance (ESG) factors or socially responsible investment (SRI).

While Fonditel is a founder member of Spainsif – Spain’s Sustainable Investment Forum – which began operating in 2009, until now, only a small part of the pension fund’s equity investments has taken ESG into account.

But in 2013, its investment policy was revised. “Our trustees specifically wanted to integrate SRI policies into the investment process,” says Martinez-Gómez. “This is the first time we have an explicit mandate from our trustees to integrate SRI policies, which led to a major change in the investment policy. We are currently working on this integration but most of it will be done next year.”

Fonditel has already started the integration process by including ESG in its due diligence analysis during the selection of private equity funds and real estate investments. Its trustees already vote at the AGMs of Spanish companies.

“The next step, which has yet to be decided, is to add an SRI tilt to our equities portfolio,” says Martinez-Gómez. “The final step will be the integration of ESG into our fixed-income portfolio.” Martinez-Gómez calls the ESG integration process one of the fund’s biggest challenges.

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