How do you approach portfolio construction?
Risk, regulation and asset allocation
Ronald Wuijster, Managing director, strategic portfolio advice, APG; ABP’s fiduciary manager
• Assets under management: €239bn
• Members: 2.8m
• Funding level: 112%
• DB scheme for Dutch civil servants
• Date established: 1922
We initially determine the risk attitude of the board of trustees in relation to the pension fund’s liability profile.
In other words, their risk attitude, liability matching and the balance sheet are the most important portfolio construction factors for us.
They create the basis for the framework in which the assets are managed. Within that framework, we first identify the balance sheet risk and form a simple portfolio with fixed income and equity only. We then take a view on the economy and add to this our expectations on the various asset classes. As the risk framework does not point toward a specific investment number but instead gives us bandwidths for the various asset classes, we can move within a certain range.
All this feeds into an asset liability management (ALM) model or tool. However, this is not only being used for normal ALM purposes but also for portfolio optimisation and scenario analysis and is altered according to different economic views. We use our own proprietary model for that but we can make use of other models as well.
The last part of the portfolio construction is the creation of the beta portfolio, which leads to a final portfolio that is fed back again to the ALM model.
Essentially, we have always had the same approach to portfolio construction but, post-crisis, the risk framework has been put together more formally than ever before.
ABP does not hedge its equity risk. The only overlays undertaken by the pension fund concern inflation, interest rates and currency risks.
The risk framework consumes most of the risk of our portfolio, ahead of the beta portfolio and active management.
We undertake a full ALM study every three years. On top of that, we produce a lighter version of the ALM study on an annual basis, which allows us to change the strategic asset mix if required, for example, if the economic environment is completely different to the year before.
Apart from global tactical asset allocation (GTAA), ABP does not undertake any tactical or dynamic asset allocation. However, we rebalance the portfolio on a monthly basis whereby we pull out the capital from asset classes that have performed well recently and move it to the underperforming assets - in short, we apply a mean-reversion technique.
All risk analysis and management is done by the pension fund’s fiduciary manager in-house. However, ABP steers the process and is fully responsible for all the decisions taken.
Deputy CEO, head of investments
• Invested assets: €29.1bn
• Active members: around 800,000
• Around 36,000 companies have insured their employees with Ilmarinen
• Hybrid of DB and DC
• Date established: 1961
Our portfolio construction is centred on asset allocation. At present, we have around 40% invested in equities, 44% in fixed income products, 11% in real estate, 2% in hedge funds, with the rest made up of other alternative investments such as commodities.
Dynamic asset allocation is part of our portfolio management. For example, we increased our equity exposure to the current, neutral level after the financial crisis. We also reduced the amount we invest in euro government and corporate bonds and sorted out our duration. At the same, we have been increasing our direct and indirect private equity and real estate investments in Finland and abroad. The main reason behind this development is our concerns about inflation, which is why we want to increase the amount of assets that are a good inflation hedge. It also boosts diversification across the portfolio.
We make use of risk models and analyse our asset allocation strategy against our risk-bearing capabilities - in other words, we look at our solvency ratio and determine what effect it has on our ability to take on risk.
The allocations to the various asset classes also depend on the risk level we apply in the risk elimination process. In addition, we use a lot of internal stress tests and scenario analysis in our risk management approach. If the analyses show that our risk model is too high we decrease our level of risk.
We conduct an ALM study on an annual basis. We start the investment plan process for the following year in September and the board of directors usually approves the new investment plan in November or December.
Around 82% of the total portfolio is managed by our in-house team. We manage all European equity internally, as well as our US exchange-traded fund (ETF) and emerging markets mutual fund exposure. It is a similar picture in fixed income where, nowadays, we even manage a part of our fixed-income portfolio outside Europe in-house. We make use of external private equity funds but do not invest in fund of fund structures. With real estate, we invest solely in listed real estate companies, trusts or funds, which are also managed externally.
We are currently reducing our external hedge fund managers in favour of our own internal hedge fund team. At present, this team looks after around 8% of our hedge fund assets.
President of management board
PBZ Croatia Osiguranje
• Invested assets: HRK6.6bn (€886m)
• Members: 280,000
• DC based on World Bank pension model
• Date established: 2001
Due to the strong investment regulations in place in Croatia, our approach to portfolio construction differs from that of other institutional investors in Western countries.
For example, we have to be invested in a minimum of 50% Croatian government bonds at all times. The regulator also imposes many limits on us, such as a 30% cap on domestic equity, a 30% limit on corporate bonds and a 20% ceiling on foreign assets.
In 2007, the regulator increased the allowance for investment in foreign assets from 15% to 20% but this hardly made a difference. However, there is an open discussion on whether in the future sub-portfolio models might be introduced. This would allow pension fund managers like us to run, for example, more active and conservative portfolios.
The quantitative investment limits very much define our investment strategy and form the basis for the construction of our portfolio. Of course, we change our exposure to equities, bonds and currency risk and diversify among and across asset classes but always within those limits.
In 2009 and 2010 we raised our allocation to foreign equity in particular compared with 2008. But due to the restricted liquidity of our domestic market, especially of the bonds, we are, to a large extent, invested passively. In fact, nowadays we are buy-and-hold players on all domestic asset classes. Between 2004 and 2006, liquidity was much higher, which made us a lot more active players on the bond markets.
When Croatia enters the EU - which is expected to happen in 2013 - liquidity in the bond markets will improve again because we will then be able to invest in and trade government bonds of EU countries.
As a defined contribution scheme with young members and few pensioners, we are still a net receiver of money. This means we do not have to think about outflows and liabilities just yet.
Our risk management involves calculating value-at-risk (VaR), stress-testing and back-testing. If we find some instruments that are too volatile we try to reduce our exposure to them, find a solution and try to rebalance the portfolio accordingly.
Our asset management is in-house, which allows us to discuss and amend our limits-driven investments every day and rebalance as required. In terms of dynamic asset allocation, we simply look for the best opportunities following market trends.
According to the law, we have to undertake everything in-house, which is why we do not even make use of external advisers.