Revolution at the top
Europe’s largest pension fund, the mighty ABP has turned its approach to investment inside out. The equity portion of the E170bn portfolio that was 75% externally managed just three years ago, is now two-thirds internally managed. The 45% that was on an indexed basis has fallen to zero – the fund is now 100% actively managed.
The man given the job of implementing this most silent of revolutions is Capital Markets CIO Jan Straatman, who sums up what’s been happening: “We are opening up a door to a completely new way of managing assets.”
When he joined ABP two and a half years ago, the basis of the discussion he had with CIO Jean Frijns was to the point. “We decided that the traditional ways of implementing strategies would not be enough to generate these types of returns required and a semi-passive approach would definitely not be enough.”
Actual and expected returns were going to be much lower looking forward and the approach that had worked through the 1990s of a generally passive exposure to capital markets would no longer produce the returns that pension funds needed, particularly with the growth in liabilities.
“The traditional philosophy behind setting up portfolios by looking at asset classes and established demarcation of portfolios by assets, regions and especially products no longer made sense in the long run,” Straatman says. “But pension funds have a unique opportunity to define what the optimal investment strategy over a longer period of time would be.”
He contrasts this with the difficulties facing commercial asset managers, as they are basically captives of the products they have developed over a period of years. “The outcome has been a move to similar investment styles which has created very similar money flows in the different asset classes and the correlations of these asset classes have increased dramatically as a consequence.” This defeats the original purpose of asset classes to diversify both returns and risks, he points out. “You may think you have a diversified portfolio, but you don’t.”
But the key issue was how to go about increasing the alpha generating capacity. The underlying philosophy is that the way to structure a portfolio is not by the traditional asset classes but to really look at how to identify inefficiencies in a market that are the source of alpha.
“What do we need to identify and exploit those inefficiencies? Our conclusion was that identifying skills rather than products really makes sense,” he says. “This meant a dramatic shift from a regional product-based organisation to a global skill-based organisation.”
Straatman and his team indentified four skills. Firstly, “Top-down skills” are demonstrated by “people with a really top-down view using thematic and macro-economic considerations when putting a portfolio together. They do not take very idiosyncratic risks, other than those driven by their top-down views.”
The second skill set needed is driven by bottom-up considerations, including individual securities selection in equities, credits and so on, driven by individual security analysis, yet not taking any top-down views. “Those with these skills would stay neutral on a global basis, but have very specialised skills on a sector basis to identify which company has the best long-term prospects,” says Straatman.
“Having split the fundamental process into top-down and bottom-up, we acknowledged that these two approaches are very different and if we allow these processes to intermingle and overlap, they will influence each other and will result in imbalances.”
Straatman says that the third skill was a very disciplined and structured approach. “This we have defined as global quantitative strategies. These strategies have the objective of collecting as much as possible from the huge information flow available and to implement processes in as dispassionate a way as possible in different quantitatively driven strategies.”
To put these strategies into effect meant the development of new implementation tools. This required significant investment in terms of new risk management and trading systems. “Since you have different strategies with independence regarding their decision making processes, the portfolio could be absorbing many unintended bets in addition to the intended bets. These could be region, sector, style, risk factor exposures and so on.”
A risk management and monitoring tool was installed that meant the fund could aggregate all the exposures “We look at a whole set of different risks, for example at
liquidity risk, exposures to emerging markets, etc, then aggregate them to the total portfolio level where we have a large overlay portfolio. This is used to manage or alter these exposures in such a way that matches our comfort levels. This lets us hedge certain risks we do not have a view on, or enables us to enhance the alpha by taking certain bets.”
The overlay allows the portfolio to be managed in a very integrated manner, particularly regarding the overall risk, he points out. “The real risk within our approach is not so much having a certain tracking error or standard deviation, but that of taking a wrong decision regarding the reliability of individual strategies, for example, the shortfall in a strategy. That’s what we manage with a very different suite of risk management tools. We monitor the shape of the distribution of the individual strategies, but relative to each other we monitor and manage the correlation of the different strategies.” This helps to fine tune and improve the overall risk return relationship, Straatman reckons.
“The structure is very simple, but the ramifications for the individual portfolio overall is quite high in the sense that the individual portfolio is the alpha engine, while overlay manages the beta, so we have truly separated the alpha and beta.”
The important aspect in his view is that the beta can be in any aspect of the market, such as regional, currency, style and so on. “We can manage all those betas independently of the alpha strategies themselves. So alpha and beta are managed independently.”
As an example, APB has build up a considerable stake in emerging markets, says Straatman. “On the overall portfolio basis, we do not only measure and monitor our explicit exposure to emerging markets, we also measure the implicit exposure in other areas of the portfolio, such as convertibles, or US stocks with emerging market activities.” Similarly, equities are exposed to credit risks and not just corporate bonds and these can be measured at portfolio level and adjustments made at the beta level.
Portable alpha strategies will be used at this level to transport alpha generation in one part of the portfolio to another at the overlay level, using the different tools available.
“The overlay portfolio has three basic functions,” he explains. “One is to take bets in a particular direction, the second is to manage the risks and exposures of the underlying strategies, third is to perform the alpha transfers between different parts of the market, whether these are by different instruments, regions or portions of exposure.”
There is fourth one, he adds, which is how much money is put into different strategies – that will be a function of the sustainability of alpha in the particular strategy. “The benefit of having a multi-asset class structure is you can see the risk exposure in the total fund and you decide if that exceeds or not the limit that you want.”
Straatman reckons that ABP is in at the front-end of an evolutionary process. “The initial starting point is the relationship between the asset owner and the asset manager, where the owner has his needs in terms of returns required and the risk levels involved. So for a pension plan, an ALM study is used, producing a required risk return profile. We work within that format. We say if you give us the desired exposure to both asset classes and the total risk/return profile we can use, with the minimum return required and the risk budget. We can allocate the assets over the different investment styles we use in such a way that on aggregated basis completely meet or indeed exceed the requirements of the original ALM model. So there is no disconnect.”
But with the advanced risk modelling tools now used with the move from product to skills-based investing will enable ABP to move to a “solution-based structure”, says Straatman.
The individual skill-based strategies are given complete freedom as to where they want to allocate their assets and the overlay is used to rebalance this according to the overall parameters the manager has been given by the capital owner. So if a large proportion of the alpha opportunities were concentrated in a particular region or currency, then overlay would be adjusted appropriately to accommodate the alpha generation.
“In the way that hedge funds have taken advantage of the inefficiencies between asset classes, it left the traditional asset managers in the area where they were trying to find alpha that is barely available, we have moved to the same space basically. By bringing down the barrier between asset classes and the type of investment process, we are able take the same type of bets and hedge away the same type of risks, but we do not leverage up those bets and take any unintended risks.”
For implementing such a concept, attracting the right people is crucial. “It was a question of finding people who understood what we are trying to do and would be excited by the challenge,” says Straatman. In particular, this was so regarding the overlay portfolio and developing that further. “We knew it would take time to have people to come on board to adapt to these concepts.” So people who were traditional stockpickers had to move to a new framework, with more concentrated portfolios with far more risk involved. Top-down managers had to focus on just thematic bets. Quant managers had to focus on specific algorithm base skills to locate inefficiences in any part of the market. “But once people see that the approach does work, then it generates its own momentum.”
External outsourced managers have an essential but non pre-determined role. “We very much look at the intrinsic added value of the individual strategy, which can be either internal or external, and then decide if the strategy makes sense. We have a dedicated team always looking at external managers and interesting ideas (see panel). One of our conclusions is that in the past where we had a number of very large bulk external mandates, on balance they were doing almost the same thing, being very close to the index, and were either just above or below their benchmark.”
Now every single strategy has to meet certain criteria, it has to have an approach that focuses on a certain inefficiency and there must be real skill connected to that inefficiency so that team implementing the strategy can exploit it on the scale ABP requires.
“By implementing this approach in a very disciplined way, we now have a very large internally managed portfolio, amounting to 65% of assets. Three years ago, 75% of assets were externally managed. This was an enormous shift that brought cost and benefits in terms of skills. But we have a suite of very effective strategies internally as well exposure to many attractive and knowledgeable external managers.” Altogether there are 90 professionals involved in capital markets in Amsterdam and New York.
The costs of handling transitions externally was very heavy. “As we were increasing our emerging market exposures, we had to come up with a better approach on the cost side.” So APB instituted its own transitioning team. “We have perfected our internal trading skills. We created more direct market access tools, which reduced our overall implementation costs on the trading side enormously.” In the skill based framework, implementation is the fourth skill.
In addition, there is a huge information flow going through the entire platform that helps individual teams to further improve their implementation, he says, which does not happen in traditional structures. “The barriers that existed before have been taken down.”
Straatman does not accept the view that there is going to be a shortage of gleanable alpha out there. “There is always going to be alpha for those with the right skills and focus. Markets are always changing and each change creates its own set of inefficiencies.” The regulatory environment creates inefficiencies and so opportunities.
The range of opportunities is determined by the skill sets of the teams. “If bottom-up security selection is a skill that our team has, if I allow them to apply this not just on equities but to high yield, then convertibles and then on private equity, it creates an even broader scope of identifying inefficiencies. There could be a moment when you say a different team that will have more skills in identifying and exploiting inefficiencies in illiquid or non listed markets. But the biggest mistake I could make is to say those teams have to be separated completely, as I do not use the opportunities in the cross-overs.”
The main advantage of this new philosophy and format is that strategies have to focus on certain inefficiencies that can be identified, exploited and are scaleable, in other words that these is sufficient capacity there for a fund of ABP’s size with E170bn in assets. “Generating alpha for such a large asset base on a 100% active basis and doing so efficiently has been a significant achievement for all involved.”
Another advantage is that “we have strategies that have a very low correlation – something we measure very closely – and an overall portfolio managed in a holistic manner with a fairly low risk profile, but where the individual strategies are allowed to take much more risk compared with the risk budget they had in the past.” The end result is that the return per unit of risk is much higher than the fund ever had in the past. “In terms of information ratios, we are in the first quartile.”