Risk separation

The 2008 asset allocation review of UBS’ Swiss Pensionskasse turned into a more extensive exercise than the fund had expected, but the fund kept faith with its strategic asset allocation. Nina Röhrbein was in conversation with Christoph Schenk, the funds CIO and recently appointed CIO and head of investments for UBS AG

UBS Pensionskasse schedules a big asset allocation review for each odd-numbered year, while smaller reviews take place in the even years. The big reviews include intense simulations and stress tests, while the smaller reviews try to establish whether the economic assumptions for the asset allocation have changed so dramatically that the fund needs to take action.

Due to the events that unfolded in the financial markets last year, the smaller review of 2008 turned into a big review. And as part of that review, the scheme’s foundation council decided to reduce the alpha allocation from 10% to 5%, which in turn increased the beta allocation.

“The 2008 review concluded in a reduction of the active and opportunistic strategies from 10% to 5%,” explains Christoph Schenk, former pension fund manager at the Pension Fund of UBS and recently appointed CIO and head of investment management of UBS. “At the same time, the risk budget for traditional equities and bonds was raised by 5% in total.”

“We have been building up our equities portfolio again since January and are currently overweight,” he continues. “Early this year, government bond yields as well as equities were down. However, the evaluation of bonds was so high that their reverse potential was so much greater than that of equities, which was the reason why we decided to return to equities. It was also why we invested in diversified yields. We believed their spreads would be the first to bounce back, followed by equities. In other words, it was a two-step programme - first spreads, then equities. In June we decided for definite to remain overweight equities.

But with the next review scheduled for October 2009, the real economy has yet to follow the upward trend of equities: “For us, the main challenge is the right timing in taking or not taking another risk because the funding ratio is still the main strife,” continues Schenk. “Although, unlike most other Swiss pension funds, we have remained at a solvency ratio of over 100% - the minimum required by Swiss law - we still used up reserves set aside for two years within one year. And we are very aware of the fact that if we have another year like 2008 they will not be sufficient. While due to our liability driven investment strategies, we are back on track with a 116% funding ratio we are not yet in a normalisation phase. A lot can still happen.”

The structure of the UBS Pensionskasse is based on the long-term, its liabilities and risk management, emphasises Schenk. “Integrating the liabilities in the overall structure automatically leads to different allocation behaviour,” he says. “We put a lot of emphasis on risk separation in order to avoid unintended side effects, which are often the result when you mix risks. When you buy government bonds, for example, you buy interest rate risks. But when you buy corporate bonds you buy interest rate as well as company risks, in short two different types of risks.”

Therefore if the pension fund wants to play interest rate risks it will buy government bonds only, if it wants to buy company risk it will buy equities or invest in asset strategies - such as corporate bonds - where only the spreads are played and it can at any time decide to take or not to take the risk. And this approach is reflected in all its investment decisions.

The fund’s traditional equity exposure, for instance, is indexed and for risk control purposes separated from the active and opportunistic strategies.

“We decide which risk we want to take where and only take one risk, not two together, at the same time to limit risk exposure and correlation,” says Schenk.

This risk approach was first taken when Schenk took over three years ago. Back then, he says, the pension fund’s bond exposure was too low and had too much of a duration risk before the portfolio was adapted accordingly.

A different, external structure with its own investment fund systems deals with the scheme’s operative risks. In addition, the fund also has teams responsible for monitoring the risk of market timing.

A foundation council sets an overall risk budget for the scheme. The risk budget is determined by matching the liabilities to the assets first by calculating the cashflow from anticipated current pension obligations and then harmonising it with the allocation of the required pensioner assets.

The fund differentiates between alpha and beta allocation: beta is pure indexation and market replication, whereas value can be added via active alpha strategies.

“The classic approach is to look at the percentage allocation of bonds and equities,” says Schenk. “However, that says nothing about the risk. Our approach is to measure the contribution of the individual asset classes towards the total portfolio risk set by the foundation council. Equities, for instance, currently make up 70% of the total risk due to other hidden exposure to them, such as through hedge fund strategies.”

The scheme’s strategic asset allocation consists of 53% bonds, 31% equities, 13% real estate and 3% active and opportunistic strategies. Private equity is included in the equity category, of which it makes up 4%.

“We do not differentiate between listed and non-listed equity,” says Schenk. “The basic philosophy of public and private equity is the same, they are pure beta investments. The difference between them only lies in the illiquidity bonuses of private equity.”
Around 5% of the equity allocation is invested in Swiss equities, while 20% are global stocks and shares. Around 2% is invested in emerging market equities.

Swiss bonds make up around 16% of the fixed income exposure, while 23% are euro-zone and 14% foreign bonds excluding the euro-zone. Apart from Swiss real estate, all investments are managed externally.

While there is no actual hedge fund quota, they do play a role in the allocation of the active and opportunistic strategies. But Schenk refers to the term hedge fund simply as a label.

“They come in different variations,” he says. “For us, it is not a pro or anti hedge fund discussion. The question is which strategies to buy in order to achieve added value. It is like buying strawberry yogurt. It is not important what it says on the packaging. What matters is what is in it, how it tastes and whether it contains strawberry pieces.”

“You have to focus on what the strategy does,” he adds. “If the manager, for example, does corporate bonds long-short, you will end up playing the spreads only. Some may refer to this as a hedge fund but that is of no interest to us. What it does and whether it is uncorrelated to the core portfolio interests us. And if it looks promising it will be included within the active und opportunistic strategies allocation.”

“At the beginning of the year, for example, we asked ourselves whether we needed to search for an active strategy that plays corporate bonds. However, our conclusion was that we would not need to do that, as spreads were too high and we could work that opportunistically with a globally diversified bond portfolio. Therefore, we decided to buy diversified yield, hold it until maturity and generate roughly LIBOR plus 260bps without paying over the odds for active strategies. In short, we do not play the corporate spreads via a long-term active strategy, we do this purely on an opportunistic basis.”

In fact, in September 2007 the pension fund decided to reduce all of its hedge fund exposure, which at its peak was at CHF2.2bn (€1.45bn), in anticipation of the credit crisis and increasingly expensive leverage.

While the strategic quota for the active and opportunistic strategies allocation is set at 3% it is allowed to go up to 8%. According to Schenk, this quota is currently exhausted due to the remaining CHF300m allocation to hedge funds, convertibles and diversified yield.

The active and opportunistic strategies have now been part of the scheme’s portfolio for three years. They are monitored daily and an investment committee meets bi-monthly to review the allocation.

Milestones in the history of UBS
• The current UBS pension fund is a result of the merger between UBS and the Swiss bank Corporation (SBC). It was officially founded on 1 July 1999 but its roots go back further in time. When it first started it used to be a fully-fledged DB fund but was more or less converted to a DC scheme in 2007. It is open to all employees of UBS in Switzerland.
• The concept of deferred pensioners is unknown in Switzerland as once a member leaves his employment and the respective pension fund, all his benefits will be transferred to the pension fund of his new employer. It also means that only the most recent pension fund will be responsible for paying out benefits.
• According to the Swiss definition, the pension fund of UBS is a hybrid scheme. Its old-age savings are defined contribution (DC) based with a pre-determined interest rate, while a defined benefit (DB) part deals with risk, death and invalidity. In other words, it is unknown today what the future pension of a member will amount to.
• However, the final salary will be insured in case of invalidity or death. Members cannot choose their individual investment lines - instead the fund chooses one strategy for all. But the invested capital and its added accumulated interest are guaranteed upon exit or retirement.


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