Investor profile: APG Asset Management US

The Dutch pension fund manager APG believes hedge funds offer one of the best risk/reward profiles for long-term investors.

European pension fund managers are not known for their love of hedge funds. Cautious and circumspect in the management of money, they have been slower to embrace absolute return strategies than their US counterparts.

APG, a subsidiary of the giant Dutch pension fund ABP, is one of the major exceptions to the rule.

Established in 2008, APG manages pension assets of around €240 billion ($303.95 billion) on behalf of ABP, the pension fund for government and education workers in the Netherlands. It also has other Dutch pension funds as clients.

Despite the financial crisis APG has not disappointed its pension fund clients. According to Robert DeRito, senior vice president and head of investment control at APG Asset Management US, the company’s investment model held firm over 2008 and into 2009.

This should come as no surprise. ABP was one of the earliest of pension funds to invest in hedge funds, beginning in 2001. Since then it has gradually increased its exposure to absolute return funds to around 6% or €13.5 billion ($17.2 billion) of its overall portfolio.

Tactical asset allocations form 2% of this while 4% or €9 billion ($11.4 billion) is invested in hedge funds through the New Holland Capital (NHC) portfolio.

DeRito says allocations to hedge fund or absolute return strategies are “very suitable for pension plans and other investors”. He sees it as a great diversifier and believes the research on and contact with hedge fund managers gives APG a unique view of the world, as well as knowledge that can be applied to other areas of investment.

APG takes a two-stage approach to its investment in alternatives. First is its strategic hedge fund portfolio which is focused on the more illiquid strategies.

The second is a global tactical portfolio. This focuses on liquid, exchange traded securities and has a directional bias. The main sources of return APG aims to capture are exotic betas, behavioural biases and exploiting differences in investment horizon. The global tactical portfolio balances the strategic portfolio, says DeRito.

“What we try to do overall is limit exposure to systematic risk. This is part of our risk strategy,” explains DeRito. “It’s a question of concentrating on idiosyncratic risk/return and neutralising ­systematic risk.”

Systematic risk is the risk associated with aggregate market returns and is basically overall market risk. Diversification cannot mitigate systematic risk.

DeRito says APG really invests in managers, rather than strategies. The organisation is looking for good ideas but also a hedge fund company that has sufficient operational infrastructure with segregation of duties and operational risk controls.

“We look at the long term,” says DeRito. “We are usually the last ones to want out of a fund early. We don’t want to expose ourselves to cherry-picking associated with early withdrawals. We stick. We believe we do best through our own vehicles, so we favour managed accounts and separate share classes. The tendency at the moment is for people to look at managed accounts as something new, but we’ve been doing them for a long time. It’s a way to gain the transparency we want,” confirms DeRito.

With hedge funds the range of options is wide, notes DeRito. “If a manager is really good but has not developed the infrastructure for his fund, we are able to have him take advantage of the benefits of a large institution like APG. We can administer the funds ourselves. This means we can take advantage of young, talented managers with good ideas but who may not have grown large enough to have the robust infrastructure we typically look for,” explains DeRito.

Determining what size of an investment APG will make into a hedge fund is a balance of different interests. Stakes range from 5% to 95% in single managers. “It took time to build up our allocations to managers. We have about 40 managers and over 50 investments we allocate to and they generally lack correlation to each other and to hedge fund indexes,” confirms DeRito.

It has taken APG years to build up an extensive network of managers. “We do extensive monitoring of performance and due diligence of the managers alongside New Holland Capital,” says DeRito. New Holland Capital (NHC), based in New York, is the hedge fund advisor to APG. According to DeRito, NHC has worked extensively with hedge funds and “knows all the right questions to ask. They are really talented people, very focused.”

“We want to see an alignment of interests with the manager and us,” says DeRito. By this he means pursuing the same goals. This means limited systematic risk and limited drawdowns.

“Absolute return is the end game,” says DeRito. “The hedge funds help us get good risk-adjusted returns over the long term.”

Average annual return since inception of the hedge fund strategies has been 6.9%, he notes, with a Sharpe ratio of 1.2.

Crucial to APG’s asset allocation is its risk management. “Overall we have three types of risk we try to mitigate. First is systematic where we try to keep a low exposure to market risks followed by day-to-day drawdown and by tail risks, which can come about when there is a correlation among hedge funds. This correlation is generally low but a systematic situation could arise and cause a higher correlation, like the 2008 liquidity and finance problems,” he explains. “A lot of hedge fund strategies were based on illiquid investment vehicles that were caught out,” he adds.

The types of risk particularly relevant for a hedge fund portfolio are the day-to-day drawdowns and trail risks when correlation comes into play. While correlation is usually low, if a systematic situation arises, the correlation will also rise.

Working for pension funds, APG also needs to pay attention to asset liability management. So extensive research and analysis of the underlying relationship between liabilities and assets in various macroeconomic scenarios are studied in order to assess the consequences of the investment policy for the pension fund.

According to DeRito around two-thirds of the investment vehicles APG invests with have liquid assets, avoiding many asset valuation problems.

“Overall absolute return carried us through less than optimal times,” declares DeRito. He believes APG came out of the crisis with its fundamental model intact and proven to be effective.

“I don’t think we have changed much because of the crisis. We were aware of the major risks of hedge funds. Between New Holland Capital and APG we devoted many man hours of careful due diligence, site visits, looking for rigorous internal processes. We review and approve each individual investment and there is extensive follow-up due diligence. We have monthly or quarterly meetings as well as an annual review. We review each investment every year. That’s standard operating procedure,” he confirms.

Even at the height of the financial crisis, DeRito believes the methods used by APG were “very robust” and protected the company from hedge fund losses. “One lesson we learned is that we need to retain control but we also need to be flexible. We need the ability to respond quickly to hedge funds. For example, if the hedge fund’s financial situation changes we may decide we should support it with more capital or quit. We’ve designed each investment vehicle so we have limited liability. That’s not new and that’s not just because of the crisis. We operated like that before. The crisis was a tremendous reinforcement of our policy,” he says.

Fundamentally, he says nothing has really changed in the way APG works with hedge funds because of the crisis. “We didn’t know the shape of the crisis or causes but we always knew we needed to be aware that there could be a crisis,” he reveals. “We were prepared to deal with the unexpected systematic or systemic risks. We were on our toes,” he adds.

Emerging from the crisis has made APG even more certain of its procedures and risk management. “We were satisfied with our preparation. It is a chastening experience when something happens. But when you know the worst of losses have been avoided, there is a certain satisfaction. We feel good about that even though it was certainly not a fun experience,” DeRito notes.

This does not mean, however, that APG has not learnt from the crisis. While it had looked very hard at the hedge funds it invested into, like many others it had not paid particularly close attention to the counterparties they used and the risks this might present.

Now APG looks “very carefully” at prime brokers and their creditworthiness as well as custodian banks and where assets are held by the hedge fund. “There is a lot of institutional horsepower added. There is no magic. We put resources into it,” says DeRito. “We are more careful about custody and financing arrangements.”

One of the most unpredictable of all risks, however, is the shape of regulation to come. While the US Dodd-Frank Act is now on the statute books, it will take 2-3 years to implement. The details of how this will be done could potentially have both positive and negative effects for hedge funds.

An even more worrying legal risk comes from Europe. No one at the moment knows what the final form of the European Union’s alternative investment fund managers (AIFM) directive will be. DeRito is reluctant to comment on a target that is constantly moving and shifting. For him until something is firmly in place APG will continue doing what it has always done: looking at the governance of the fund and continued intensive legal and investment due diligence.

Like others in the industry DeRito has seen a steady and continuing shift towards institutionalisation as institutional investors continue to move into hedge funds. He concedes there is a difference of opinion. Some say pension funds need hedge funds. But their demands for robust and institutional-quality operational risk controls could squeeze out the smaller funds.

Nevertheless, DeRito remains optimistic about the future of small hedge funds. “Entrepreneurs are springing up all the time. Most hedge fund managers are coming out of the prop trading desks from the banks. That trend will probably increase,” he says. There is also a generational change.

One good outcome of the financial crisis DeRito believes is the move towards greater transparency. “A lot of managers, especially European ones, are feeling pressure to be transparent.” However, DeRito is aware that it is what investors do with the information that is important. He recognises it needs to be processed and used by the investor, something APG is geared up to do.

Looking ahead to the next decade, DeRito strikes an optimistic note. “Hedge funds will be alive and kicking, partly because the baby boomers and change in demographics demands absolute return strategies. I think that during the crisis hedge funds did not completely escape public approbation. But it is a robust business. It can change. The regulatory environment will change. This may encourage more hedge fund investment. I’m very optimistic for the future of hedge funds over the next 10 years,” he concludes.