When passive becomes active

As with many schemes in recent years, the €81bn Dutch giant PGGM, which serves some two million active and deferred members and pensioners, has staged a major overhaul of its investment process. The project, which was initiated in 2006, is based on PGGM's belief that the classic pension fund investment policy centred on allocating assets to different investment classes has become an inefficient means of extracting the highest possible returns.  PGGM's solution is to separate beta - returns from passively benchmarked investments - from alpha, which is excess returns most commonly associated with active management. PGGM believes it can get extra from its beta investments.

"Our beta management focuses on the efficient implementation of PGGM's total multi-asset class beta exposure," the scheme begins. "With a very tight risk budget, our objective is to deliver the targeted return from the aggregated beta portfolio at low cost, whilst remaining flexible enough to accommodate reweighting in the portfolios."

Finding practical solutions to this new philosophy did not come easy and PGGM was faced with certain challenges. "Firstly, index management historically focuses predominantly on individual asset classes. There is no clear management style for global multi-asset class beta portfolios," says the scheme. "Next is the problem of scale.

Our beta portfolio is large and well diversified. It has assets of €60bn, invests across eight asset categories, uses 35 mainly customised benchmarks, is divided into 60 portfolios and 10 financial products."

Such a large structure is likely to change often and PGGM says it frequently has to rebalance the beta portfolio. "The portfolio has to be constructed by taking into account certain liquidity requirements and furthermore it comprises both internally managed and externally managed sections."

PGGM is a large and experienced organisation and no stranger to overcoming hurdles. It worked out a planned solution to the above challenges by integrating different disciplines. "We have a track record of being innovative in implementing new products and instruments. Using our economies of scale and scope, we have been able to sample and focus on risk factors in fixed income which enable us to construct portfolios tracking benchmarks closely but without fully replicating them," says PGGM. "As for equities, we have accumulated enough experience and knowledge to be able to operate confidently in illiquid markets. Similarly, for commodities we are experienced enough to avoid leaving a footprint in the market."

Experience is often not enough. Implementing large-scale changes to a huge portfolio requires self-belief and dedication. "We have strong convictions that our integral portfolio management will pay off. There are offsetting risks in the portfolio and there are cost/benefit trade-offs to help identify where we can reduce tracking errors," the scheme points out.

PGGM argues this can be achieved by managing the various underlying portfolios integrally with one value-at-risk budget for the aggregated beta portfolio. "This gives us flexibility to manage our portfolio far more efficiently than managing all the underlying portfolios in isolation."

According to PGGM, there are multiple ways to implement beta and it expects its product innovation to continue. "We have the skills to use these developments to our advantage. As market segregation leads to price differentiation in various beta instruments, we can identify and exploit inefficiencies."

Based on its conviction and experience, PGGM has developed its own beta management style allowing it to integrally manage its multi-asset class beta portfolio with one overall risk limit for the aggregated portfolio. "We call this the Sophisticated Matching Approach (SMA)," PGGM says. "To ensure we achieve our objective, for every exposure decision, SMA makes a trade-off between three factors: risk, cost and flexibility."

This integrated approach means PGGM can take more risk in bonds to reduce costs by scaling down its risk in equities. "By using one risk budget for the overall portfolio and selectively choosing where we take risk, pay costs and create flexibility, we ensure the targeted return of the total beta portfolio is delivered in the most efficient manner," it suggests.

This trade-off is made at three different successive levels in the integral beta portfolio:

Level 1 - Allocation. This covers the various submarkets in PGGM's strategic benchmark. Level 2 - Instrument selection replication. This covers the instruments used to replicate the submarkets, such as cash index portfolios, futures, options, total return swaps, exchange traded funds and private placements. "We are constantly looking for efficient implementation opportunities across all possible instruments." Level 3 - Securities selection replication. This concerns the actual securities used to replicate the instrument, such as those in cash index portfolios. "We are looking for a balance between low tracking error and low total costs. There is a point where reducing risk is balanced by the rising costs of implementation."


Of course PGGM does not invest blindly and relies on analysis to ensure it selects the best instruments, benchmarks and securities. "The trade-off between risk, costs and flexibility is evaluated through constant focused research and market views. This approach enables us to construct a portfolio that tracks the target return closely and adds value at very low risk."

Such is its confidence in its integrated SMA approach, that PGGM says it is ready to take it the next phase by incorporating both liability-driven and socially responsible investments and it is happy for others to copy its style. "SMA has been specifically designed for PGGM but can be utilised to meet the needs of a wide variety of institutional investors. It is scalable in size, risk profile and liquidity requirements. By wisely using the small risk budget that every index portfolio inherently has, we have changed the pay-off dramatically from a sure loss due to costs to an expected profit. Making beta management truly active!"

Without having to enlist the help of costly active managers, PGGM has looked at inventive and active ways to use passive management from its existing benchmarked portfolios to get that little bit extra as active managers promise.

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