Post-crisis pension fund strategic asset allocation

Pension investing is a long-term game – but the financial crisis forced most funds to adjust their strategies to meet the demands of short-term volatility. The impact of this experience has been felt differently across Europe. Clive Davidson reports

The financial crisis didn’t so much send investment and risk management strategies off course as blow them right out of the water. Common assumptions proved ill-founded, while conventional market theories suddenly looked naïve and hopelessly optimistic. Investors have had to review their approach and try to adjust to a new world characterised by uncertainty, and no-one is affected by this more than pension funds, whose whole rationale is to protect, and hopefully grow, savings capital over time using the markets.

Looking at the response to the crisis of a number of Europe’s biggest pension funds, it is clear there is no single right answer. In fact, the funds are having to negotiate their way through an unstable and changing world, evolving their strategies to the new circumstances as they go along. One of the risks they face is the impact of new regulation and the brighter spotlight on their performance, and the danger that this might divert them from their primary goal of investing for the long term.

Hollow theories

“The financial crisis exposed the hollowness of some of the theories that have underpinned a lot of market activity,” says Andrejs Landsmanis, head of strategic asset allocation at First Swedish National Pension Fund (AP1), which has Skr181.4 billion (£15.6 billion) of assets under management (AUM). Calculating metrics such as value-at-risk and correlations can give indications of risk, but they don’t tell the full story. “What we are doing is enhancing our understanding of the inherent risk of the whole portfolio on a higher qualitative level, looking at the driving forces behind the assets we hold,” he says.

Some assets react in certain ways to an inflation regime, others to a deflation regime, whether there is high or low growth, or surprises in inflation or growth. “We are trying to apply a macroeconomic framework, which could lead to different conclusions on how our assets will behave and correlate with each other, compared with using more traditional risk metrics,” says Landsmanis.

Since the crisis, AP1 has overhauled the way it structures its fund and its investment strategy. “We now place a large emphasis on beta [returns relative to/above benchmark] and strategic asset allocation and we have downgraded the relative importance of alpha [systematic risk (or market)],” says Landsmanis. “All our emphasis today is on capital allocation.”

APG, a Dutch provider of asset management and administration services to pension funds, with €240 billion (£197.6 billion) of AUM, responded to the crisis by adjusting its asset liability management (ALM). “We looked at the way we measured correlations and volatility and made that more time-varying and regime-dependent,” says Ronald Wuijster, managing director, strategic portfolio management, at APG. The organisation also decided to make more use of stress testing, looking at extreme conditions and outcomes beyond statistical expectations. “Risk is not just a statistical notion – it can arise from a variety of sources, such as regulatory changes,” says Wuijster.

APG is paying more attention to credit risk and replacement risk, as well as the risk that surged into the spotlight during the crisis – liquidity risk. “We were aware of liquidity risk and managed it quite well during the crisis. But we probably underestimated it, so we have to focus further on it.” APG has since turned the liquidity risk measurement techniques it was using into a more formal tool.

AP1 has adapted its currency hedging techniques to factor in liquidity risk more strongly. “The crisis proved what we already believed was the case, that liquidity is the key parameter, and when it is not there markets cease to function,” says Landsmanis. While its main portfolio is generally liquid, AP1 is a long-term investor so also looks for illiquidity premiums.

“In that sense we can afford not to sell when everyone else has to sell, but we don’t want to be forced into a position where the portfolio has an overall composition that we are uncomfortable with. We have bandwidths for exposures in terms of percentages of the total portfolio that we will tolerate under very severe circumstances, and we check everything according to those criteria,” says Landsmanis.

One almost universal response across the investment community to the crisis has been to pull back from more complex instruments. APG was using a wide range of instruments to achieve its strategy, but since the crisis, its goal has been to reduce complexity. “It’s not that we don’t think derivatives are useful – they are – but if we can achieve our goals using simpler investment instruments, they have a preference,” says Wuijster. He quotes Einstein’s aphorism: “Make everything as simple as possible, but not simpler” as a guiding principle.

Regulatory pressure

Universities Superannuation Scheme (USS) is the UK final salary pension scheme for university and higher education employees, and has nearly £30 billion of AUM. Elizabeth Fernando, deputy chief investment officer of USS, says the fund is thinking of buying some inflation swaps, but only as part of a risk-reduction strategy.

“[Prior to the crisis] we were already evaluating a more dynamic approach to our strategic asset allocation, which establishes a link between our funding ratio on a gilts basis and our allocation to risk-reducing assets. Inflation swaps could be included in the risk-reducing allocation in future, and we have started the education process with our investment committee, but no investment has been made yet,” says Fernando.

The crisis has understandably scared the regulators. Under pressure from politicians, who are in turn under pressure from their constituents, they have been tightening their regimes and trying to close perceived gaps, resulting in what APG calls a ‘watchdog environment’. “This increased regulation and oversight is to a certain extent good, but will lead to slightly lower returns than the environment we were in before,” says Wuijster.

Furthermore, tighter regulation that includes requirements such as frequent mark-to-market valuation can be an issue for pension funds because it can encourage them to behave a bit more like investors with shorter-term horizons, say some funds.

“One of the characteristics of an efficient market is that the different market participants have different time horizons – some short, some middle and some long-term,” says APG’s Wuijster. “If everyone has the same horizon it leads to higher volatility. I’m not saying we have suddenly become a short-term investor – that is not the case – but there are regulatory developments that push a bit in that direction, and that is a worry.”

USS’s Fernando says triennial actuarial valuations – which the UK pensions regulator reviews to decide if deficit contributions from the fund sponsors are appropriate – can apply a pressure that can be at odds with a fund’s need to generate long-term capital growth. “As one of the very few open, defined benefit schemes in the UK, and with an immature liability profile, our optimal strategic asset allocation will look very different to the majority of pension funds. Being different from the crowd can be uncomfortable, particularly when return-seeking assets are performing poorly, but this does not mean staying in the herd is appropriate,” she says.

In addition to the regulatory pressures, the increased volatility and overall uncertainty of the markets can pull pension funds towards a shorter-term horizon.

PGGM, the Dutch healthcare and social workers pension fund with €89 billion of assets under management, says the current fragile state of the global financial system can lead to a rapidly changing view of the world. “The term ‘riskless’ doesn’t apply to government bonds any more,” says Jaap van Dam, PGGM’s chief investment strategist. “Our horizon is shorter than it used to be. We increasingly act in a flexible way to cope with market circumstances, always with longer horizon objectives in mind.”

Time horizons

Fernando says: “In highly volatile markets, it is easy to get swept up in short-term gyrations and lose focus on what your real objectives are. Although we incentivise our fund managers on their two- and five-year performance records, monthly and quarterly data is available and inevitably becomes a topic of discussion, both internally and with the investment committee and board. But our competitive advantage [as investors] lies in being able to take the longer-term view. Therefore, having strong investment beliefs and a disciplined investment process is key.”

The AP1 fund is a buffer fund for the provision of Sweden’s state pension, and its rules of operation are defined by the country’s parliament, which hasn’t altered them since the crisis. Nevertheless, there has been increased attention on the performance of the fund from the general public and the media. “Since the risk we do have in the fund is properly handled and meaningful, we feel we have to enter the public discussion, although it seems this discussion tends to have a more short-term perspective and to evaluate things on a more reactive than strategic basis,” says Landsmanis.

In this brave new world of volatile and uncertain markets, pension funds are faced with considerable challenges. “The biggest is how you assess your tactical asset allocation positions when you have a high percentage of illiquid or unquoted assets in the portfolio, for example real estate or private equity, whose valuations are only available with a considerable delay,” says Fernando of USS. “We estimate valuations where we can, but we always have to remember they are best guesses and are likely to be subject to revision. We have put renewed emphasis on being aware of our cash position and forecasting cash demands.”

AP1 says its major challenge is that the current financial and economic environment is one of instability. “When you have instability you have liquidity risk, because at some stage the markets can just stop functioning,” says Landsmanis. “We also have a lot of non-linear outcomes because things that were seen as impossible previously now appear possible.”

“The crisis marked a turning point in very long-term trends, and we have to adapt to that change,” Landsmanis continues. “A lot of mainstream theory that underpinned the markets hasn’t held up under scrutiny. Markets can be rational some of the time, but we don’t believe they can be rational all the time. Traditional risk metrics don’t work well, so you need a more dynamic approach. But a more dynamic approach means a less structured approach, which leads to other problems, such as how do you quantify risk and risk-adjusted perfomance?”

There is no clear way forward, says Landsmanis. “We have to build portfolios and create returns in a situation where we can’t do any proper forecasting, so we have to think in different ways about possible scenarios and risk diversification.”

Higher-frequency trading of assets is not the answer. “If you look at the past 10 years’ returns in the markets, they have been flat and negative in some markets such as Europe and Japan,” says Landsmanis. “But if you look at trading volumes over the same period, they have increased massively. All this frenzied activity is an attempt to get a return from an asset that doesn’t give a return – it is illogical behaviour.”

Where pension funds could once rise above the fray of the day-to-day markets and ride the long-term trends with reasonable confidence, now they have to try and second-guess a decidedly uncertain future. In doing so, they are having to take a far broader view of risk and create portfolios that are resilient to whatever the markets might throw at them.

ATP – the move to absolute returns

In 2003, ATP, the Danish public supplementary pension provider with more than €100 billion (£82.3 billion) of assets under management, decided it would hedge all of its liabilities.
Having done so, it then decided it would make more sense to have an absolute return target
for its investment portfolio.

“Going from a benchmark world to an absolute return world, we needed to know much more about our absolute risks,” says Anders Svendersen, vice-president and investment and hedge portfolio manager. To help it measure its risks, ATP implemented the Risk Manager risk management system from New York-based RiskMetrics Group (now part of MSCI), and widened the range of its investments beyond the classic pension fund portfolio of equities and fixed income.

“We divided our portfolio into five risk classes – rates, equities, credit, inflation and commodities. Then we looked at each risk class and asked which cash instruments we already had, which we needed, and what derivatives overlay we needed in each of the risk classes,” says Svendersen.

Then in 2006, ATP did an analysis of its asset allocation. “At that time, one of the parameters that was important to us was the ability to reduce our risk by 30% within two weeks.” To ensure this, ATP adjusted the allocation of its portfolio, establishing an appropriate balance between liquid and less liquid assets in each risk class. In addition, “because we know our diversification strategy doesn’t always work”, ATP hedged its extreme exposures in equities and oil.

By the onset of the crisis in spring 2007, ATP already had its strategy in place. “We were in the happy situation where we had a balanced and very diversified portfolio, we had an insurance strategy for hedging our tail risks, we had a risk system to measure absolute risk on a daily basis, and we had an asset and liability model that looked at our risks on a longer-term horizon, which we had developed in 2000.”

This overall strategy, plus the fortuitous fact that the fund had not completed all its investments in less liquid assets, meant ATP weathered the crisis well. However, following the crisis, the fund has reviewed its strategy in light of the events that were more extreme than it had anticipated, asking what would have happened had it been fully invested in its planned less liquid instruments. This has led it to adjust its asset allocation to enable it to reduce its risk by a further 30% within a month after its initial 30% risk reduction.

“We were lucky with our timing in terms of developing our strategy before the crisis,” says Svendersen. “It has proved a good strategy, but that doesn’t mean we can just sit back and say it will work forever. We have to stay on top of it. The situation won’t be the same next time.”