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The importance of a 'see-through' process

Roland van den Brink outlines the Dutch Metal Workers pension fund investment framework to Fennell Betson The Dutch pension funds are living in a storm that is unlikely to abate for some time. The forces swirling around them will determine not just their future shape, but in some cases their continued existence.
Roland van den Brink has no hesitation in choosing the eye of the storm as the safest place to operate from, provided you are prepared to adapt to its vagaries by acknowledging the risks. He is head of investment policy at MN Services, the investment arm of the country's fourth largest pension scheme, covering over 34,000 employers and 300,000 active members in the metal industry pension fund, BPMT.
He divides Dutch funds' attitude to risk into four phases. The first was the period before 1975, when everyone was very risk-averse and fixed income the solution". The next decade brought the search for diversification through stocks and real estate but with stability of returns, Then came the need to match inflation in the 10 years up to 1995.
The latest phase is that of the "investment framework", with its emphasis on maximising returns within acceptable boundaries.
For Van den Brink this is an issue not just of the industry-wide schemes' survival, but has much wider ramifications. "Global competition is all about returns." Though pensions assets per capita are about equal in the US and in the Netherlands ($27k), the cost of providing future pension assets will require an average contribution rate of 4.7% of GDP in the US and 12.2% for the Dutch for the foreseeable future. "So if Dutch society wants to compete globally with the US, it has an 8% GDP disadvantage because of pensions costs."
This alarming fact was the main reason the Dutch government wanted a quality check for the mandatory industry-wide schemes. "Last year's legislation for industry-based schemes allows employers to opt out and go elsewhere if the policy is not up to normal professional standards or if the actual performance deviates too much from the benchmark over a period of five years. But the accountability is in reality more stringent than that, as he points out: "The most important aspect of the legislation is that anyone can ask about a fund's investment approach and industry-wide funds must reply with information about their policy and performance."
In 1993 MN organised itself on a team basis to deliver its risk-controlled investment process for its E16bn fund. The actual management of the overlay was handled by a team, which decided on the timing, the markets, the extent of leverage and on the question of currency overlays. Recently, instead of running the fund as one pool it was split into what Van den Brink refers to as "mandates" for which one portfolio manager is responsible. "This was because the fund had grown so large and in a team approach the individual qualities were sometimes hidden." Hans Rademaker has been appointed as director financial investments, looking after the fund's range of mandates.
There has to be, in Van den Brink's view, a 'see-through' process to move from the information yielded by the asset/liability study through to the benchmarks and from there to the mandates for the internal and external managers the fund uses.
On an ALM basis the fund is split 50% in nominal assets and 50% in real assets. On a yearly basis, the board of trustees decides on a benchmark, which the investment team is expected to outperform. Van den Brink says "there has to be a clear link of the profile that is used in the ALM study and the yearly benchmark".
Six indices are used in the ALM study reflecting the long term strategy, two per asset category (fixed income: euro government bonds and global high yield; equities: developed countries and emerging markets; real estate: direct and indirect investment). The indices should have a low correlation. "With ALM we determine our long-term benchmark, but as short-term market volatility is not constant, you cannot take 20-year or other historical numbers and match these to very short-term models. So we make this link on a three-year horizon using a value-at-risk approach in that the daily standard deviations of the long-term benchmark and the (suggested) yearly benchmark are measured on a weekly basis. So when a link is made between the long term and the short term it is done in today's market conditions."
Deviations in the yearly benchmark are made to ensure that the risk profile is in line with the long-term benchmark. "For 1999 we have decided to hedge 50% of the US dollar exposure." The necessary calculations are done by Bankers Trust in London and are designed to show "where the bets are being taken in the yearly benchmark".
"Mostly we keep our portfolio in line with the benchmarks. So you know the fundamentals of your portfolio." BPMT, like most Dutch funds, has an active overlay programme, he says. "We implement our tactical view through plain vanilla derivatives." Here long and short strategies in all liquid markets are allowed and up to 9% leverage can be applied. The derivatives used are always one-directional and only for the very liquid markets. As Van den Brink observes, if a fundamental market change, such as a major interest rate rise, is expected , the fund is too big to go into the market and sell. It can only lower its interest rate exposure by using interest rate derivatives. So the overall position of the fund at any point can be different from the benchmark. The "enhanced alpha" the fund hopes to achieve could be of the order of 100 basis points, he says.
The overall shape of the benchmark is that fixed income, including private loans and cash, comes to around 50% of the portfolio, with a six percentage point tactical range. New is a 4.5% allocation to emerging market debt and 1.5% to high-yield corporate debt. The equities proportion has grown fast from 6% in 1993 to around 35% now, with a 4% tactical range.
Real estate amounts to 15% of the assets. The currency exposure outside of the euro is limited to 55%. Netherlands assets account for 60% of the total.
The fund does not have the specialised skills to cover the 20 or so markets it invests in. Around 70% of equity portfolios are in the hands of outside specialists and 5% is held in investment funds, leaving 25% internally managed, mainly in a pan-European mandate. The active managers have to deliver additional returns above their benchmarks and the return net of fees above the benchmark is constantly monitored. In all, around 18 specialised equity managers are used.
MN, says Van den Brink, "expects managers to outperform their benchmark; not to make market timing decisions. This way a manager can add extra value for us." Controlling and analysing the information flows of managers are essential activities and this the fund does through its global custodian Citibank, which collects the data, to be analysed by Wilshire in Santa Monica."

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