Strong, diversified returns repay pace-setting strategy
Since ABP set up its hedge fund strategy in 2002, it has been a pace-setter in the Dutch pensions community, and as such is a worthy winner of the Netherlands award. ABP was one of the first funds to build its own best-in-class hedge fund investment programme, on a par with the top commercial funds of funds.
At first, the effort was concentrated on hiring investment talent with hands-on experience in numerous hedge fund strategies, as well as developing comprehensive due diligence procedures.
But in contrast with other pension funds which have built up in-house teams that passively select funds from those on offer, ABP has stayed one step ahead by pursuing innovative strategies and working actively with external managers to create new customised funds. Funds of funds now make up only 15% of the total hedge fund portfolio.
Throughout all this, ABP has pursued five objectives, which have largely been achieved: high absolute return, low risk, low correlation with other assets, meaningful scale and controlled operational risk.
Over the past three years, ABP’s hedge fund portfolio has grown substantially. Although it makes up only 3% of the fund’s total assets, ABP is one of the larger hedge fund investors in the world. Its hedge fund investments are now worth around $6bn (€4.8bn), with the vast majority in direct allocations.
The first objective of any hedge fund portfolio is to produce strong returns, and ABP has been outstandingly successful in this. The pension fund’s target is an equity-like return (in today’s environment, roughly equal to cash rates plus 4%), with low risk.
Since 2005 - a challenging year for hedge funds - overall returns have been equal to cash rates plus 3.3%. ABP’s direct allocations outperformed both its fund of funds investments and the relevant hedge fund indices.
On a risk-adjusted basis, a Sharpe ratio (ie, the excess return per unit of risk) over 1 is considered to be excellent for active management. Since inception in 2003, the Sharpe ratio for ABP’s hedge fund portfolio has been 2.3.
However, to be considered true alpha, excess returns should also possess two other characteristics. First, the returns should be largely independent of other risks in the overall portfolio. Second, the pattern of those returns should have a normal distribution, and not be negatively skewed. In these terms, ABP’s portfolio has produced noteworthy results.
ABP has incorporated an unusually comprehensive set of explanatory betas to separate out the returns attributable to alpha from those attributable to market conditions. These include such parameters as small cap/large cap exposure, interest rate sensitivity and yield curve sensitivity.
For a typical pension fund, these systematic betas explain more than 90% of the total portfolio variance. In contrast, since 2003 they have explained less than 10% of the variance of ABP’s hedge fund portfolio, and that percentage has declined further over the past year. So not only have returns been strong - they have also been independent and highly diversified.
In addition, the returns have avoided the negative skew arising from exposure to rare, but severe, drawdowns. This has been achieved by a combination of avoiding strategies with short optionality and an active programme of hedging.
ABP and its hedge fund team are increasingly seeking new ways to achieve the desired returns objective using non-traditional investments. Early on, ABP took a significant position in catastrophe bonds, where the return is linked to natural disasters. This kind of investment, though uncomfortable, is well-compensated and is fundamentally uncorrelated with other risks in the portfolio. More recently, ABP has worked with its managers to build tailor-made products on an opportunistic basis, such as those which exploit mispricings in the explosive collateralised debt obligation markets.
In all of these aspects, the careful evaluation and balancing of risks has been an integral component in portfolio construction, and ABP attributes its consistently high returns to the craftsmanship with which this has been carried out.
The approach it has adopted towards the organisational structuring of the hedge fund activities is equally innovative.
Recent rapid changes in the hedge fund industry have meant that a robust business model was necessary to guarantee a successful continuation of the hedge fund operations.
So ABP created a business model combining the focus, customisation and control of an internal team with the specialised skill, intensity and incentives of a commercial fund of funds organisation.
To achieve this, ABP has spun off its hedge fund group into a new company, New Holland Capital, also based in New York. ABP believes it is the first pension fund to make such a radical change. The new company is led by the former co-heads of ABP’s internal hedge fund group - Tom Dunn, Ira Handler and Adam Field.
In contrast with a purely internal team, the company is better able to attract and retain skilled staff, to build to a meaningful scale and to further develop specialised systems and infrastructure.
Compared with the typical fund of funds model, New Holland is more cost-effective, more narrowly focused, more transparent, subject to greater control and better aligned with ABP’s long-term investment objectives. ABP’s overall goal is a long-term sustainable model that best exploits the current opportunities, while maintaining the highest levels of controls and business standards.
Highlights and achievements
With its radical hedge fund programme, ABP has achieved the best of both worlds, in matching in-house expertise with the skills of external managers to create tailormade funds. Its hedge fund portfolio has achieved high absolute returns, currently running at cash rates plus 3.3%. These returns have been achieved in a manner largely independent of other risks in the overall portfolio. Furthermore, these returns have avoided the negative skew associated with many hedge fund portfolios. ABP has also spun off its in-house team into a new company, allowing it to better attract skilled staff and develop specialised systems, while giving better control and more cost efficiencies than would be gained from using a typical fund of funds.