The hedge fund industry could be the saviour of pension funds and in the process grow five or even 10 times larger than it is today, according to Cern Pension Fund CEO Theodore Economou. He says the way forward is for pension funds to use the same sophisticated risk management tools used by the best macro hedge funds to lower volatility and achieve better returns.
What to many will sound like a radical proposal was a direct response to the aftermath of the financial crisis. Before 2008 the Cern Pension Fund, established in 1955 to provide for the employees of the European Organisation for Nuclear Research as well as the European Organisation for Astronomical Research in the Southern Hemisphere, was a traditional fund with 60% invested in risk assets and 40% in fixed income and cash. The losses the fund experienced in 2008 caused the board of trustees to consider whether that investment strategy was based on outdated assumptions.
In 2010 the board formally adopted a capital preservation approach with risk management at the core of the investment process.
“At Cern we invest our entire Sfr4 billion [$4.1 billion] pension fund as if it were a large global macro fund,” explains Economou. “We manage towards an absolute return target using a risk roadmap. We use sophisticated risk management tools to achieve the smoothest ride possible with the least amount of risk possible, resulting in our portfolio having a Sharpe ratio in excess of two.”
Economou believes the Cern model should be replicated by other pension funds because it offers a way to help the industry meet the significant challenges it faces.
Relative market outperformance is no longer sufficient. Instead of a mostly passive approach relying on long-term risk premiums, pension funds need to minimise capital losses in the medium term and capture sufficient market upside to meet actuarial return objectives: an approach that requires dynamic management of the portfolio’s risk and capital preservation.
For pension funds unable to replicate the Cern model in-house, Economou suggests they turn the entire pension fund portfolio over to a top hedge fund company to manage. He also urges pension funds to “completely revisit your investment governance to focus on two things: managing risk and maximising the return you get for the risk you are taking”.
Economou believes the best hedge fund managers have “an extremely valuable skillset” that pension plans can use to deliver their own objectives. According to Economou the largest hedge funds are highly sophisticated entities that do three things extremely well: control risk; move in and out of asset classes with great flexibility; and achieve significant returns with very little volatility.
“This skillset is exactly what pension funds need to address the challenge they face. But today this skillset is being woefully underutilised,” he says.
One of Economou’s first steps after taking over management of the Cern fund was to bring the hedge fund skillset into the pension fund. “For those contemplating managing risk as well as return, it’s important to know that this skillset exists. I believe this is where the hedge fund industry has a tremendous opportunity to step up to the challenge with products that address the overall challenge that pension funds are facing.”
Such risk techniques are used only on slices of pension fund portfolios, when Economou says they should be applied to the entire portfolio. “What I am advocating is that the entire pension fund be managed with the same discipline and processes as the best hedge funds.”
The Cern Pension Fund adopted a risk driven capital preservation approach in 2010, followed by a major overhaul of its investment governance structure. Reconciling the fiduciary duties of the fund with this dynamic approach required a new governance framework, spelling out adequate investment principles and incorporating independent daily risk control as well as new metrics to measure performance.
This updated governance structure enabled a comprehensive control framework at board level while allowing the investment team to act quickly and effectively in constantly changing market conditions.
Most pension funds seek to achieve less volatility in return profiles by adding a few uncorrelated investments, including hedge funds, in their portfolio. While Economou agrees this is a good first step, he wants to see the hedge fund industry offering solutions and products that address the entire pension fund portfolio, particularly the objectives of achieving risk-adjusted returns with relatively low volatility.
“What distinguishes the most successful hedge funds is very sophisticated risk management. At Cern we have incorporated this risk management technology into the management for the entire portfolio. We believe this model is the ideal one for pension funds,” Economou says.
Both pension funds and hedge funds need to look at the problem from a different point of view than at present, he believes. “There is already pressure at the pension fund level from stakeholders to move in the direction of taking risk into account in addition to returns. As this pressure builds, trustees will increasingly seek to not only meet their long-term objectives but also protect pension funds from losses,” he says.
On the other side the hedge fund industry will need to create products that not only contribute to reduced risk in just a part of the portfolio but also address the challenges of the overall portfolio. These specialised mandates would be tailor-made to specific criteria specified by the pension fund in co-operation with the hedge fund. Only when the hedge fund understands the entire pension fund portfolio can it help to design specific investment solutions, believes Economou.
Although most pension funds at present allocate at most 5% to alternatives and many even less directly to hedge funds, Economou is still optimistic the industry will change.
“We are already seeing an increase in the allocation to hedge fund investments,” he advises. In order to manage risk better, pension funds should ask hedge fund managers to apply their risk management technology to traditional mandates outside the hedge fund bucket. One option, for example, could be to use hedge fund managers for long-only investments such as fixed income and equity.
At Cern, Economou looks at the entire portfolio and at all investment regardless of the asset classes or strategy on the basis of the expected return compared with the risk of loss that is implied by the investment. “This is the common denominator and it percolates all the way up to the management of the entire portfolio.”
When these factors come together, the overall portfolio should be much more efficient in converting risk taken into return.
“We manage the pension fund to preserve capital. What this means is that our overarching constraint is to be positioned in a way to avoid losses exceeding a certain pre-agreed amount in the worst case. Within that, our process, which incorporates risk management overall and within individual investments, we seek to select investments that maximise the return potential for the incremental risk that is being taken.”
Modelling the portfolio after the most successful macro funds, Economou’s team chooses individual investments from a wide range of asset classes and strategies. The process incorporates the same flexibility that is needed to manage risks while delivering low volatility.
“Over the three years since we switched from the traditional model to what we call the Cern model, we have multiplied the efficiency of taking risk and converted it to return by a factor of 10. It is bringing this risk awareness in the process that has had the most impact in that achievement,” he declares.
Although the model being advocated by Economou may sound radical, he believes pension funds need to be less traditional in order to be more conservative. That thinking led him to adopt a model where risk control is the over-arching parameter for the fund.
Many will question whether pensions’ boards of trustees will be as eager to embrace such a novel concept. Economou’s own board incorporates scientists and government officers as well as pension experts. “It is to their credit that they have recognised the return challenge facing the fund, the need to reconcile avoiding losses with reaching a long-term objective. As a result they fully supported the required changes.”
His advice to pension funds is that the idea of a traditional conservative portfolio is no longer compatible in a world that is undergoing rapid and major changes while pension funds are facing challenges due to lower interest rates, low yields, weak sponsor finances and adverse demographics.
“We’ve been very pleased that the Cern model appears to resonate very positively in the industry. We have received numerous requests regarding the governance we have put in place, the risk management discipline that is embedded in the fund and the change process that took pace. I believe passionately that the Cern model is ideal to address the challenges pension funds face.”
The Cern governance model is designed to accommodate a dynamic and flexible asset allocation process. The process starts with addressing what really matters to trustees: what losses can be accepted, what is the investment return objective and what are any constraints in terms of liquidity and allowed instruments.
“Only after setting these boundaries does the portfolio get built to meet those objectives. You could say we have taken the traditional process and turned it on its head. Instead of building a portfolio and advising the trustees of its risks and returns potential, we first ask the trustees to establish the risk levels with which they are comfortable, their objectives and then have a governance that ensures we have a portfolio that meets these constraints at all times,” he explains.
The asset allocation process starts with this overall risk target. A macro analysis process then identifies the market regime and environment in terms of risks and opportunities.
“We compare this to the risk profile of our portfolio as it is described by our risk analysis tools. We then seek to identify opportunities to improve the ratio of return expectation to the inherent risk of the portfolio. We will regularly add or subtract investment with the objective of maximising what we call the efficiency, the ability of turning risk taking into investment return.”
Cern uses hedge funds as a model for determining what the overall macro environment looks like. “This process is really where the best macro hedge funds excel. We are inspired by that process, which seeks to identify by strategy type, and lay out the return expectation and the near-term and long-term risks. We then put all these together and are able to rank where opportunities lie. We are then constrained by the overall portfolio risk so that we are led into a particular allocation at any one time that attempts to marry the highest possible efficiency in respect of the risk limit for the overall portfolio.”
The macro view has to reconcile and recognise two conflicting trends: an unprecedented effort to inject liquidity by nearly all central banks worldwide and underlying economic weaknesses in many parts of the world and particularly in the developed world.
“Our process seeks to achieve a balance between these two different trends. Flexibility and risk management are key to have an effective process,” he says. “Today the major themes in the portfolio seek to leverage the benefits of the worldwide impact of quantitative easing. At the same time we focus on high-quality assets in order to protect the portfolio from adverse developments.”
Cern’s internal team manages the overall allocation in which there are individual hedge fund allowances. Hedge funds also manage the traditional mandates.
“Among our most successful experiences has been a collaboration with a top 50 hedge fund renowned for its sophisticated quantitative models and its long track record of high risk-adjusted returns. It developed for Cern a traditional long-only product but with the ability to dynamically manage exposure. This is a prime example of the ability of a hedge fund to transfer its risk management technology to traditional mandates and in the process serve a much larger part of the portfolio,” explains Economou.
As to what vehicles are used in those allocations, Economou says the decision depends on the constraints of the investor. “There is no best solution. We tend to favour [commingled] funds providing the liquidity that is appropriate because it allows us flexibility in allocation. Other investors may favour managed accounts, provided of course they have the ability to set up the infrastructure that goes with it.”
While this approach might seem to exclude emerging managers, Economou says their skills should be leveraged but “with appropriate caution”. In Cern’s process such decisions are made at the investment process stage.
The investment committee that advises the fund focuses on setting the investment process as well as the controls to ensure the process is efficient. The committee considers all new investments.
However, allocation among existing investments is delegated to the staff. This gives maximum flexibility and allows them to act quickly to ensure the portfolio is always adequately positioned.
“The criteria for using the investment committee are to maximise what we call the governance budget. In other words the amount of time the committee can devote in allocating its expertise, attention and time to the pension fund. The role of the committee, therefore, is to provide leadership in setting the objectives in terms of risk that is acceptable in relation to returns in terms of constraints for liquidity and acceptable instruments.”
Economou believes leaders in the industry on both sides of the Atlantic are starting to move towards a model that looks more like what he has built at Cern. “We are at a crossroads. Models are emerging to do that. We believe the Cern model is perfectly suited for that and I’m convinced that 10 years from now this model will be adopted much more broadly,” he says.
“We will continue to do what we do. My greatest challenge is sharing [the model] with the pension fund industry and at the same time encouraging the hedge fund industry to share its technology, to contribute its unique skillset in delivering high risk-adjusted returns to the pension fund community. This is the biggest challenge but I believe in it and will continue to spread the word.”
Theodore Economou was the winner of the European Single Manager Award 2013 for outstanding contribution to the industry by an institutional investor.
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