A pension fund that sets itself apart from the rest

Originally published in the February 2008 issue

A fund increasing the proportion of its assets allocated to hedge funds from 3.5 per cent to 5 per cent may not sound like a big deal. But when the company in question is ABP, Europe's biggest and the world's third largest pension fund, the absolute size of the investment is considerable. What's more, this allocation to hedge funds is just one strand of ABP's ambitious strategy towards alternative investments. The Hedge Fund Journal travelled to ABP's Amsterdam office to learn more about the investment philosophy behind that strategy.

ABP is the pension fund for Dutch government and education sector employers and employees. It has 2.6 million members and an invested capital of more than €216 billion (end of 2007). ABP was formed in 1922 under the control of the state. In part because of the conflicts of interest caused by the government trying to reconcile public finance considerations with the financing needs of its own pension scheme, ABP was privatised on 1 January 1996 and now functions independently.

During the period of government control ABP was permitted to invest outside the Netherlands only in a very limited way. Since privatisation, ABP has been able to pursue a far more diversified investment policy – both geographically and across different asset classes. The benefits of that diversification are plain to see in Figure 1.

Despite testing market conditions ABP's overall return for 2007 was 3.8 % and the pension fund has achieved an average annual return since 1993 of 7.9%. The average real return of 5.9% over this period was well above the prudent return of 3% that is assumed for the purposes of setting pension contributions.

The group sets out its investment strategy once every three years, with the latest plan running from 2007-2009. "The overall strategy is decided for a three year period, then there is an annual investment plan within the scope of the longer-term policy," explains Paul Spijkers, ABP's Chief Investment Officer for Alternative Investments.

Compared with the 2004-2006plan there are significant changes to ABP's investment policy. The Dutch supervisory authorities recently introduced a New Financial Assessment Framework (nFTK), which emphasises market-based valuation. Pension assets and liabilities now have to be valued on the basis of market value, a short-term solvency test has been introduced and there is a greater focus on the mismatch risk between assets and liabilities.

In response, ABP is currently developing a portfolio approach that is split into two major components. The first, which goes by the working title of the "liability-hedging portfolio" (LHP), will be created to mirror the group's liabilities. The second, higher-risk component, known as the "risk-optimising portfolio" (ROP), aims to generate as high a return as possible within certain risk limits. The new framework provides an explicit link with the pension fund's liabilities, which will allow improved coordination between investment decisions and the interests of the fund.

Tailoring the needs of an ageing population

The relative sizes of the ROP and LHP portfolios will be determined by the structure of the fund's liabilities and the nature of the pension deal it offers. At present ABP has one pension product for all its participants, which is not age-dependent. But, as Spijkers explains, the new framework opens up the possibility of developing new products more closely linked to individual customer needs. ABP is currently investigating these possibilities.


"Theoretically it is possible to create any risk-return profile by mixing the two components and a link can be made to 'generation-based' investment portfolios. When you are young you have more time to accumulate capital to finance the pension you would like to have and can take more risk. When you are older you would like the stability offered by the capital you have already built up and therefore want less risk."

While it is not currently possible to give a precise breakdown of the asset allocation between the LHP and ROP components, clearly, given the rapidly aging demographic profile of ABP's fund participants, the LHP will be by far the largest part.

A shift towards liability-driven investment is often accompanied by a focus on long-term fixed income strategies. ABP, however, is far more focused on real returns. "We have real liabilities, because in our pension product the ambition is to fully compensate for wage inflation," explains Spijkers. "So ideally we are looking for investments with an index-linked component. That's easiest to find with index-linked fixed income products, but it is not limited to that. Several types of real estate and infrastructure investments also have those attributes."

Roderick Munsters, Chairman of the Board of Directors of ABP Investments, writing before the launch of the 2007-2009 plan, encapsulated this philosophy as follows: "Whoever wishes to realise a real return will have to invest in the real economy." He explains that investing in fixed interest securities has been very much in vogue in recent years because the cash flows from these investments can be more easily reconciled with nominal commitments. But as Munsters notes, "interest is only interest, it remains nominal and quite sensitive to inflation. What you will get is firmly established and does not move in keeping with the economic cycle. This does not relate well to our objective, which is to realise a real return. For this reason we will have to keep investing in the real economy."

This approach is clearly visible in the allocation between real assets and fixed income securities in ABP's strategic investment portfolio (see Table 2). Over the course of the latest investment plan the allocation to real assets will rise from an already substantial 56% to 60%. Closely related to this focus on real assets is a shift in the new investment plan towards a greater emphasis on absolute returns rather than performance relative to benchmarks.

Spijkers, who has the experience from a career spent entirely at ABP to draw on, notes that traditional investment strategies, which seek to outperform a benchmark, do not necessarily relate well to a pension fund's objective, which is finance its liabilities. In years when returns are negative in absolute terms the fund may still have outperformed its benchmark, but will not have done well in terms of meeting its future financial obligations.

It is surprising to find that one of the world's largest institutional investors has an investment philosophy more commonly found in the hedge fund industry and this certainly sets ABP apart from many of its peers."There are not many large institutional investors that have actually put an absolute return focus into practice," confirms Spijkers. "We are one of the first, if not the first, certainly in terms of scale. A lot of institutional investors do have an allocation to some extent to absolute return strategies, but not as their central philosophy."

"Are we setting a trend? We feel this is the best way to approach the investment process. But it's not our intent to start a trend," adds Spijkers with a laugh.

Portfolio composition will not alter dramatically overnight in response to this change in focus and neither will the process be completed during the life of the current three year plan. But ABP has taken a step towards its goal by increasing the allocation to alternative investments to 25% in the current plan from 20% in the previous three-year period. Hedge funds are part of the alternative investment allocation along with real estate, private equity, infrastructure and commodities. Table 3 shows the asset allocation breakdown between those different classes, which includes the planned increase in hedge fund investments from 3.5% to 5%. "Of that 5% strategic allocation, 1% will be managed within our global macro portfolio and 4% in the hedge fund portfolio," says Spijkers. "In dollar terms we currently have about $8.5 billion exposure in the hedge fund portfolio, but to reach 4% that will have to rise to about $12 billion, so we are not there yet."

In keeping with the focus on absolute returns, ABP believes that generating alpha yields a valuable contribution to the return on the portfolio, with little increase in the overall risk. Distinguishing true alpha, however, is not easy. ABP tries to create a hedge fund portfolio with as low a beta as possible, keeping to a minimum that part of the return which is explained by common market factors. "Take merger arbitrage," says Spijkers. "Ten years ago it was a novelty, with a low correlation to market factors and the returns were probably alpha. Now you can go into a library and pick up a book on merger arbitrage and do it for yourself. It is still a return profile that is not highly correlated with common market factors, but it is more of an exotic beta."

Not only does the nature of the returns alter as a strategy attracts capital inflows, ABP accepts that the size of those returns may also come under pressure. But while it may be reasonable to assume that risk premiums for a particular strategy may diminish as they become more accessible, this is not the same as an expectation that returns for all hedge fund investments will fall over time. ABP's approach, therefore, is to avoid popular, readily accessible strategies and look more at areas that have higher barriers to entry, or are complex and illiquid in nature. The end result is a portfolio that has between 50 and 60 strategies in it. Unusually, over half of the portfolio is with hedge fund managers or strategies that had no established track record when ABP first invested with them.

"The main focus of the hedge fund portfolio is to look for new strategies. Even if you might be able to classify some of our strategies within one of the well-known categories, such as global macro, they will always in some way be differentiated from the mainstream."

Given ABP's focus on seeking the road less travelled, Spijkers is understandably reluctant to provide specific details of the strategies that he thinks will be the best performers in the coming year. He can divulge, however, that despite last summer's market turmoil, the overall hedge fund portfolio has performed well, returning 13% with 2.5% volatility in 2007. Correlations also rise during a crisis, but this too is an area of potential pitfalls that ABP has avoided.

"We monitor our portfolio for signs that correlations are rising and hence whether adjustments are needed. Up to now we have had a portfolio in which only 15% of the return is explained by common factors. For the main hedge fund indices the comparable figure is commonly over 50% and in some cases is 60-70%," explains Spijkers. "The credit crunch has not led to our correlations shooting up, either in relative or absolute terms."

Obviously, periodic market dislocations require a degree of flexibility from a fund manager. The use of an annual investment plan within the context of the broader three-year strategy is designed to help deal with the fluctuations of the market. Also, given the gradual evolution of the strategic portfolio and the longer-term investment horizon that ABP is able to adopt, there has yet to be a market crisis that has required the abandonment of a three-year plan part way through its execution.

Investment in innovative strategies

The constant search for new strategies has also prompted ABP to allocate 2% of its capital under the new plan to "innovative strategies". Spijkers emphasises the need for a distinct organisational structure to facilitate the implementation of new ideas. If a mechanism is not in place where people are stimulated to look beyond their own immediate field of expertise and where they are facilitated in taking an idea to the next stage then there is a tendency for good ideas to fall by the wayside and not be implemented.

To this end ABP has set up a separate innovation committee with its own asset allocation. Not only is the structure helping generate ideas in completely new fields, but ABP has also used the innovation committee to speed up the process of investing in an existing field. While, once again, reluctant to reveal details of new departures, Spijkers identifies ABP's investment in timber as an example of the innovation committee expediting the investment process.

A large fund with a focus on new and often untested investment ideas runs the risk of becoming constrained by a lack of liquidity in specific strategies. "It's definitely not as easy as investing in equities. You can't just pick up the phone to your broker," observes Spijkers. "So far we have been able to build up our portfolio over time and I believe we can achieve our strategic asset allocation goal. There is a skill involved in getting access to the best managers and strategies and in this respect the name that we have built up in the hedge fund space works to our advantage. Managers now approach us with strategies."

This reputation is also helpful in gaining the required level of transparency in ABP's hedge fund investments. ABP does not invest in black box strategies. For an investment to be deemed suitable it must be both understandable and plausible. Part of that understanding is derived from gaining insight into how a particular portfolio is managed, be it either on a daily or monthly basis. When it comes to acceptable levels of leverage that hedge fund managers apply to their strategies, rather than apply a single metric across the whole portfolio, ABP makes an evaluation on a case-by-case basis.

Among the other asset classes grouped under alternative investments the largest allocation is to real estate, although this will drop slightly from 10% of invested capital to 9% over the course of the 2007-2009 plan. ABP, however, no longer invests directly in bricks and mortar, having decided that too sizable an organisation was required to adequately manage the risks associated with a physical property portfolio.

"Most of your company will end up managing your real estate portfolio, running the risk that you become myopically focused on property," explains Spijkers, who believes that similar returns from real estate can be garnered from a combination of holdings in listed companies, private funds and joint ventures.In a similar vein, ABP's commodity portfolio has been built up through futures markets rather than physical commodities. While there are no plans to move into physical commodities in future, diversification is currently being considered into investments in businesses related to commodities, for example agri-business companies.

The approach to commodities is largely a passive holding strategy. Exposure to different commodities broadly follows the allocations found in the major benchmark indices, such as the GSCI, which have a relatively high exposure to energy. This is advantageous for ABP, given energy's correlation with inflation. Apart from the activities of a relatively small actively managed fund in the commodity group, ABP does not seek to capitalise on short-term movements within any one particular commodity. It does, however, take longer-term views on the relative value of different commodities compared with one another. For example, taking a view on the long-term relative value of energy products compared with metals and adjusting the fund's relative exposure.

Investment in private equity is expected to rise from 4% to 5% of invested capital in the current three-year period, although finding suitable projects is not always easy. "Private equity opportunities have picked up in 2007, although it is definitely a crowded area. We believe that a successful strategy should be focused on the top quartile of private equity houses. The difference in market return between the average and the top quartile is huge. This limits the universe that we can step into, creating a capacity constraint."

ABP also recognises the labour-intensive and specialist nature of investing in private equity – from identifying targets, through executing a turnaround strategy to securing an exit via one of several different routes. For this reason ABP conducts its private equity investments through its subsidiary, AlpInvest, which operates at arms length from ABP Investments.

Despite infrastructure being a hot sector in the last couple of years, ABP has not encountered difficulties in matching its desire for sector exposure – the 2007-2009 plan includes an allocation to infrastructure for the first time – with suitable opportunities. With a three-year objective to reach an asset allocation to infrastructure of 2%, ABP is currently on, or even slightly ahead of, schedule.

Shifts in regional allocation

In addition to allocation shifts between different asset classes, ABP also envisages changes in the geographical spread of its investments. In future a greater emphasis will be placed on emerging markets like Asia and South America at the expense of developed markets such as the US. Spijkers confirms that this shift is based on an assessment of the relative future growth potential of the respective areas. Equity allocations under the 2007-2009 plan, for example will drop from 34% to 32%. Within this overall decline, however, developed market exposure is expected to decline by 3.5 percentage points while emerging market exposure is set to increase by 1.5 percentage points.

This view of the superior growth prospects of the developing world is, however, a long-term view, rather than merely a reflection of the current fashion for economic 'decoupling' – in which the global economy is kept afloat by the strength of emerging markets even in the face of a US slowdown. Spijkers believes in decoupling to a certain extent, but does not think that it will happen as quickly as the consensus view might suggest. Spijkers' and ABP's views on the rest of the macroeconomic outlook reflect the perspective of a longer-term investor with an ability to adopt what it describes in the strategic investment plan as an 'attitude of patience'.

"We still feel that we are in a situation where there is a relatively small likelihood of a full recession, but at the same time we are not expecting strong growth," observes Spijkers. "As pension fund managers [having the ambition to offer index-linked pension products] we would obviously like inflation to be as low as possible. While we don't expect a major jump, inflation is likely to rise and we are building up our inflation hedge, not as a short-term tactical ploy, but as a long-term strategy."

Changes in asset allocations within the fixed income portfolio reflect this view of inflation. Overall exposure to fixed income securities is targeted to fall to 40% from 44%. Allocations to government and corporate bonds will decline by a total of 7 percentage points, but exposure to index-linked bonds will rise by 3 percentage points over 2007-2009. At the same time the duration of the fixed income portfolio will increase to bring the characteristics of the assets more in line with the fund's liabilities.

While Spijkers believes that, over the longer-term, markets tend towards a stable equilibrium; inevitably there will be short-term crises which have an impact on investor behaviour. For example, last summer's problems in credit derivatives will have an impact on investors' attitudes towards certain fixed income products. "You need to take a very hard look at structured credit. Last summer's events will have woken people up to the fact that a AAA rating doesn't mean that there is no risk. You can't make decisions on the basis of the credit structure's rating alone, but must judge the risk of the underlying securities." Despite the turmoil, Spijkers highlights that ABP's total return for mortgage-backed securities will be positive in 2007.

Can ESG factors sit side by side with absolute return?

Ethical considerations are also incorporated into ABP's investment process. In 2005 ABP laid out its stance on socially responsible investing, becoming the first pension fund in the Netherlands to publish a Statement of Investment Principles. ABP believes that the companies in which it invests must take all their stakeholders' interests into account. If stakeholders act in the same spirit a virtuous circle of responsible business can be created. But there are also sound financial reasons for pursuing a socially responsible strategy. Until just a few years ago, environmental (E), social (S) and governance and ethics (G) factors were not included in the financial analysis of a company's future prospects. Consumers, however, are increasingly influenced by how a company responds to ESG factors. These topics are not always covered in a company's financial statements, but they are particularly relevant for a long-term investor such as ABP.

Spijkers is very clear about the growing financial importance of social responsibility as an input to the asset allocation process. "If you ignore the impact of ESG, then you will miss a large factor in the generation of future returns. Portfolio managers should include ESG criteria in their financial analysis. That's a basic belief."

Supporting this view, ABP's investment plan refers to recent academic research that has found a positive correlation between adherence to ESG criteria and financial performance.

While ABP's pension fund members can take comfort that their investments are being managed with a social conscience, are they as comfortable with the focus on absolute return strategies? "Given that our hedge fund strategy is to invest in new products and managers, this makes it in part an uncomfortable process, because it is unknown. To this must be added the public perception of what a hedge fund is and does," explains Spijkers.

"There will be hedge funds that blow up from time to time, such as Amaranth, and this has an impact on public perceptions. People perceive hedge funds as risky, but if you look at the low 2.5% volatility that we achieved on our hedge fund portfolio last year they are clearly not that risky. An institutional investor, before he starts to invest in hedge funds, must accept that these perceptions must be managed, which can be a difficult job."

Changing something as nebulous as the perception of an investment category that the general public does not fully understand may indeed be tricky. But when it comes to the more concrete matter of harnessing the benefits of absolute return investment to deliver consistent real returns in excess of long-term objectives, Spijkers and ABP are right on track.