APG's Change Without Regret?

Thao Hua of Pensions & Investments reports, European institutional investors to lean more on hedge funds:
European institutions — led by the U.K. — are expected to raise or change their hedge fund allocations in a bid to improve funding levels while better controlling portfolio volatility, industry observers say.

Hedge fund allocations among pension funds in the U.K. — Europe's largest pension market by the amount of defined benefit assets and its largest hedge fund market by investment assets — could as much as double in the next several years, sources said.

In 2011 alone, the average pension fund allocation to hedge funds jumped to 4.1% — or about £33 billion ($52 billion) — from 2.6%, according to data from the National Association of Pension Funds.

Consultants such as Aon Hewitt are recommending that some pension funds could make an allocation to hedge funds of 30% or more within the return-seeking portfolio, depending on the risk/return target of the fund, said Guy Saintfiet, U.K. head of liquid alternatives at Aon Hewitt, based in London.

Estimates are not available for the overall expected growth rate of hedge fund investment flows for Europe.

Furthermore, institutions are also altering hedge fund strategies to reduce correlation, illiquidity and beta exposures.

The e246 billion ($322 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands, reshaped its hedge fund portfolio in 2011 to target more precise alpha. APG Asset Management, which is the fiduciary manager for ABP, added opportunistic hedge fund strategies “in the distressed area and certain types of arbitrage in the insurance sector” in the past year, said Ronald Wuijster, Amsterdam-based chief client officer and managing director of strategic portfolio advice for the firm, which has about e275 billion in total assets under management.

Others strategies, including some in market-neutral that contained too much beta exposures, were dropped by APG. Hedge funds should be “only aiming for alpha,” Mr. Wuijster said. “We have almost no beta exposure in there.”

In 2011, ABP's hedge fund portfolio returned 6.1%, compared to -5.13% for the HFRI Fund Weighted Composite index. ABP allocated about 4.4% of the total portfolio to hedge funds during the same period.

In the Netherlands, U.K. and elsewhere in Europe, regulatory pressures on solvency levels are pushing institutional investors to seek hedge fund strategies that target more consistent “bond-like” returns, rather than high-octane alpha, sources said.

“Investors are attracted to hedged strategies, and part of that is using hedge funds to reduce risk,” said Stephen Oxley, London-based partner and managing director at Pacific Alternative Asset Management Co., which managed $8.2 billion in global hedge fund assets.

Because of the historic low interest-rate environment, more investors are seeking to add “hedge funds that have similar volatility to bonds with less interest rate risk,” Mr. Oxley said. Others are using highly liquid, less directional hedge fund strategies within a liability-driven investing framework so that “if bond yields move in either direction, you have some protection.”

While the majority of institutions still place all hedge fund assets into one bucket within the alternatives portfolio, some are beginning to view allocations differently as a way to improve performance and lower volatility, said Mr. Saintfiet of Aon Hewitt, whose firm advises on about $30 billion in hedge fund assets globally. “Certain investors no longer see hedge funds as a separate asset class, but as a way of managing risk within asset classes,” he said.

For example, they might add credit hedge fund managers to the credit portfolio, move hedge funds that invest in high-yield debt into the fixed-income category and shift a portion of the equity portfolio into a long/short strategy or even a global macro hedge fund to diversify risk, several sources said.

“Investors are using hedge funds in a more pointed way than ever before,” said Morten Spenner, CEO of International Asset Management, a hedge-fund-of-funds firm based in London. “They're more specific in terms of the exposure they want and how it will fit into the overall portfolio.”

Haven't delivered

From a correlation to equity perspective, hedge funds haven't delivered in 2011. For example, the HFRI Fund of Funds Composite index had a 0.89 correlation to the MSCI World Index. However, beta was very low in 2011, estimated about 0.23 compared to same index. “Volatility has been around 3% since 2008,” said Mr. Spenner, whose firms has about $2.5 billion in assets under management. “In other words, capital preservation was largely achieved,” he added. “That's why hedge funds should be a particularly important consideration in this environment.”

Furthermore, performance has been improving. In January, the HFRI Fund Weighted Composite index added 2.63%, the second highest monthly returns since December 2010.

At Britain's Pension Protection Fund, London, executives don't have a specific allocation target to hedge funds. “We think the hedge fund space is very diverse and, as you would expect, we select our exposures carefully,” said Ian McKinlay, CIO of the �9 billion PPF. “We seek to allocate to specific strategies which help diversify our risks or where we can find managers who can exploit specific opportunities. ... These opportunities may be time-bounded.”

Mr. McKinlay estimated the PPF's hedge fund allocation has probably doubled in the past year, and accounts for 5% to 10% of total assets. While Mr. McKinlay declined to say whether the PPF plans to further add hedge fund exposure, other sources familiar with the fund estimate its allocation could again double within the next couple of years, depending on a variety of factors such as market conditions.

“Hedge funds bring risk management to the table, protecting the downside,” said Luke Ellis, head of the multimanager business at Man Group, London, which has a total of $58.4 billion in assets under management. Mr. Ellis oversees about $14 billion in hedge fund-of-funds assets, the majority of which are institutional.

At Towers Watson & Co., more clients are seeking diversified hedge fund exposures focused on alpha, typically targeting returns of four percentage points above the London interbank offered rate, net of fees. “The key here is diversity in the building blocks that offer decorrelation and diversification,” said Craig Stevenson, senior investment consultant in hedge fund manager research at Towers Watson, based in London. Towers Watson has about $26 billion in assets under advisement on an implemented consulting basis in hedge funds.

“The evolution over the past 18 months has been a focus on minimizing beta — targeting 0.2 or less beta exposure — with managers with different exposures and investment styles,” Mr. Stevenson said.

Mr. Oxley of PAAMCO added: “One of the best ways to produce lower beta is through portfolio construction, with the right mix of strategies, so that what you've got left is more alpha. Alpha is the ultimate diversifier.”

Lawrence Berner, London-based executive director and portfolio manager for Morgan Stanley Alternative Investment Partners' hedge fund-of-funds division, said investors are “more and more averse to loading up their hedge fund strategies with beta when they CAN do it much cheaper elsewhere.”

“Liquidity has also become a more important factor for clients,” said Mr. Berner, whose firm has about $13 billion in hedge fund assets under management and advisement.

Although many pension funds realize they might have too much equity risk in the portfolio, the timing might not be right to make a big shift into bonds because of low funding levels and low interest rates, several sources said. As a result, they're looking to both diversify bond assets and evolve the growth portfolio through hedge funds.

“More clients are accessing hedge funds in a way that they may not be willing to before,” said Simon Fox, principal within Mercer's alternatives boutique based in London. “We continue to encourage (clients) to see hedge funds as a way of reducing the risk within growth portfolios by increasing their diversification across risk factors.”

Excellent article but take it with a grain of salt. While investors are increasingly looking for "non-correlated, liquid absolute return strategies with little or no beta", the truth is most of them are getting advice from pension consultants who've never invested in hedge funds, plowing more money into large brand name hedge funds, thinking they're doing the right thing. In most cases, all they're doing is feeding large asset gatherers collecting 2 & 20, delivering mediocre results.

Then there is APG, the fiduciary manager for ABP, one of the largest pension funds in the world and arguably the best hedge fund investor in the world. They manage billions in hedge funds through New Holland Capital and unlike most pension funds piling into hedge funds, they know what they're doing (you can read this June 2007 document on their hedge fund investment strategy but they have revamped their portfolio since then).

Why do I like APG? Because when it comes to hedge funds, they know how to invest in real alpha and they're not afraid of taking intelligent risks. Amanda White of top1000funds reports, APG-backed hedge fund incubator expands:

IMQubator, the emerging manager fund of funds backed by APG, will establish an international capital introduction network, as part of a plan to attract institutional investors in addition to the Dutch giant.

APG has backed IMQubator since IMQubator’s establishment in 2009. The chief executive of IMQubator, Jeroen Tielman, says in the next three months institutional investors from the Middle East, Asia and Europe will assemble in Amsterdam to meet APG.

APG, which is the asset manager for the €235 billion ABP, has a seat on IMQubator’s investment committee, which is also open to up to four new investors, providing they commit between $25 million and $50 million.

APG allocated funds to IMQubator from its innovation bucket, which makes up 2 per cent of the fund.

IMQubator provides capital to hedge fund managers in return for a stake in the hedge fund company and reduced management fees, around 1 and 15.

The capital provides an important asset for hedge funds in start-up phase. IMQubator has seeded nine managers, which have expertise in a variety of hedge fund strategies, and a tenth is imminent. IMQubator claims to be leading the charge for the new generation of alternative investment management.

Tielman says restoring “the balance of power” is a condition of seeding.

“The seeding phase is the only moment in the business lifecycle when a business is really open,” he says. “Hedge funds have the opportunity to listen to investors. It’s an opportunity to change the governance of hedge funds.”

While Tielman says pressure on fees is important, it is also worth recognising hedge fund management is skill based.

IMQubator focuses on managers with talent, entrepreneurial skills and passion that have concentrated, specialist, pure strategies, and where risk management and control are a natural element.

The company also recently partnered with Hong-Kong based multi-manager firm Synergy Fund Management to source and seed Asia-Pacific managers.

Synergy and IMQubator will form a business development advisory alliance with a focus on China and Japan. Synergy will source Asian managers, while IMQubator will advise Synergy on seeding and accelerating hedge fund managers.

I don't know about Asian hedge funds. Reuters reports that 2011 was a rough year, exposing the long-only bias of many managers' portfolios, leaving the industry fighting a tough battle to retain clients as assets shrink and fund closures accelerate. However, APG and their partners know this and are looking for market neutral funds.

More importantly, APG is doing exactly what I've been telling large Canadian pension funds to do, namely, start seeding emerging funds right in our backyard. There is no question about it, sophisticated pension funds should be in the seeding game. Problem is they are too scared to think outside the box and their board of directors are more worried about the media than about taking intelligent risks in hedge funds and other investments.

Finally, earlier this month, I&PE's Liam Kennedy spoke with Angelien Kemna, chief investment officer of APG, the Netherlands’ largest pension asset manager with AUM of €278bn, about her policies of ‘minimum regret’ and ‘controlled simplification’, and reports, Change without regret:

The Netherlands’ most powerful woman is keen to communicate her values, or at least those of her organisation. APG’s culture is different from that of a commercial asset manager, says Angelien Kemna, chief investment officer. “We realise that we manage a lot of money, also for a lot of people who do not get large amounts of pensions,” she says. “Individual managers here, top to bottom, realise this is captive individuals’ money.”

Owned by pension funds including ABP, the largest in the Netherlands with assets of €235bn as of September 2011, APG was created in March 2008 from ABP to comply with government regulation that required the separation of the pension fund from its executive operations, including administration and investment management. In September 2008 APG merged with the building sector pension fund’s Cordares, which at that time had assets of almost €30bn. Since then, APG has acquired other clients, including PensPlan in Italy, for which it manages a €100m mandate. The organisation had AUM of around €280bn as of end-2011.

Through ABP, founded in 1922, the Netherlands was an early adopter of funding for pension liabilities, although the institution changed course dramatically in terms of investments when it was privatised in 1996. It then became an independent entity and undertook a major programme of asset diversification under Jean Frijns as CIO, moving away from a portfolio primarily of Dutch government debt.

Kemna, named most powerful woman in the Netherlands by the feminist magazine Opzij in autumn 2011, has been CIO of APG since November 2009, succeeding Roderick Munsters. Indeed, alongside Ho Ching of Singapore’s Temasek, she is one of the few women globally to achieve a position of such seniority in institutional investment.

Since Kemna arrived at APG from academia – she is a quant by background and previously worked for ING – the CIO has introduced a policy of controlled simplification to the investment portfolio. This has meant re-evaluating the portfolio in terms of its overall goals but also from the perspective of the members and pensioners: “It is looking ultimately to our overall client portfolio that matters.”

First comes the choice of benchmark or ‘smart beta’ – non-standard benchmarks – which APG has embraced. For instance, €40bn of its €70bn developed equity portfolio is run using ‘smart beta’ benchmarks with a basis point fee and almost all internally “that is probably lower than anywhere in the market for an external mandate” as Kemna puts it.

Controlled simplification also means reducing complexity in the overall portfolio in terms of the strategies and instruments that are used. “What adds to performance?” the CIO asks. “Can we not move with bigger, simpler steps, back to basics to say we don’t need all these difficult instruments? We have already taken out a lot of derivative instruments that do not add value and only make things complex.”

Not everything is out though, and there is a commitment to hedge funds, for instance. Indeed, APG is the sole client of the fund of hedge fund manager New Holland Capital (NHC), which is based in New York and owned by its partners. APG will continue to use it, although with Kemna’s caveat: “You have to show to the outside world, if you add very expensive hedge funds through NHC, that they do add value to your client portfolio.”

And quant is certainly in – APG has one of the biggest quant portfolios globally with €30bn in developed market equities and what Kemna describes as “an extremely good team”.

The controlled simplification process means critical attention on external managers, which currently account for 24% of assets. In practical terms, this will not favour managers who think too much in terms of their own business, performance fees and “generating alpha by twiddling here and there”. APG has “defined much better what we really want from them and what we really do not like”, the CIO says.

“We think in terms of a certain strategy; within that we ask, does this external manager fit as an addition or does he do exactly the same as we do? We typically don’t want those anymore, they really have to add value. Also, on the illiquid side we see a lot more focus on valuation both from the regulatory authorities and from our clients, so we demand more transparency there as well. This year we are going to test how many external managers of illiquid assets in which we have large investments can bring us the valuation and transparency that we want. We will be very critical of our external managers.”

Managers of small accounts will also be terminated: “If I have external managers doing a brilliant job but only on €33m in a developed equity fund out of €70bn, then I really don’t think I need them. That won’t do either in the context of controlled simplicity.”

The majority of the controlled simplicity “homework” has been done, Kemna says. Now the task is to examine in a structural way how financial markets are developing. “Is diversification still working? Should we shy away much more from traditional benchmarks either to non-traditional ones or ones closely related to liabilities? Now we have settled most of the controlled simplicity programme and we’re down to execution, we’re also trying to rethink where we stand. Financial markets have changed a lot and given that we better understand our culture and what we do things for, how can we start adding new thinking that helps us with our goal?”

As one would expect, APG’s senior staff espouse a variety of views on the current state of capital markets and the wider economy. In common with other Dutch pension funds, APG sold out of Greek debt but still holds Italian government bonds – part of what Kemna terms a‘minimum-regret’ portfolio that aims to reduce downside risk in the event of a disorderly default. Some hedges are in place, but not to reduce the upside potential assuming a relief rally on capital markets, even if a sustained relief rally seems far off.

“If you have diversification of opinion, it helps you having a minimum-regret portfolio. It won’t urge you to do too many unnecessary actions. It has been my opinion for many years that if there is such a diversity of opinion you should not take either the one bet or the other, because that is not a sensible strategy for the longer term. Timing is the most difficult thing in asset management decisions as we all know.”

In the short term, Kemna says it is clear that the ECB needs to play a bigger role “because the nervousness is too high”. She adds: “For the medium term if you look at the sheer size of euro liabilities – and they will continue to grow – there is a huge demand for a safe, liquid euro bond market. I know you need extra measures on the fiscal side and on the guarantee side but if there is a clear-cut, well-defined market it will compete with the US and a lot of money that has flowed to the US will flow back to Europe.”

APG believes that its asset diversification has functioned effectively overall since the 2008 crisis, although Kemna says this is due, in large measure, to the illiquid part of the portfolio. “Our credit portfolio has done extremely well this year, as has some of the illiquid part, while we have seen that emerging market equity was the poorest performer over all,” she says.

“Currently, we continue to look at the portfolio as a whole, the role that all the asset categories have in building the client portfolio and the risk factors that are underlying them. In the last couple of months we have been giving a lot of thought to whether these high correlations are going to stay or not. If they are going to stay then we need to do some extra homework. We are not the only ones looking at these high correlations and it’s my guess that we will see many papers going forward to address these questions.”

Now APG plans to manage risk differently, although not in the same way as ATP, for example, which manages five pre-determined risk classes (rather than traditional asset classes) at the overall portfolio level.

“We always look at the liability profile, the assets we have and their role towards the liabilities. Given the high correlations for the various asset categories, we are thinking of taking things a step further and looking at whether there are other ways to create diversification. Or are the risk factors we are using sufficient, given the changes in the market we are seeing?

“Increased volatility and increased correlation between the various asset categories is something we certainly worry about. We are also rethinking the way we achieve diversification in long-term themes that are not necessarily correlated. We will look at changing benchmarks, moving more from beta to smart-beta, considering themes like healthcare for an ageing population, or scarcity of food and water and how we can play this theme for the next 10 years, at least, to make sure that in this part of our portfolio we look into some of the diversification. That will be done next year or the year after.

“Maybe it will encourage people who have more resources than we have to do some thought processes for us,” Kemna muses, thinking of ways to unleash academic firepower to the benefit of APG and others.

With the forthcoming introduction of the new national pensions agreement, the Dutch supplementary pension system is moving away from a system that focuses on nominal pension rights to one that focuses on real rights – in other words, recalibrating the financial assessment framework (FTK) to take into account the fact that the ambition of the system is to provide increasing pensions in line with inflation.

Kemna is aware of the law of unintended consequences, especially when it comes to such a significant financial player as the €800bn Dutch pensions industry. She warns that policies must be tested thoroughly for unwanted effects and that pension funds must not move in tandem into inflation-hedging assets in order to avoid future bubbles.

“If €800bn is going into all kinds of inflation assets, then that won’t work because we will create our own bubble. So I don’t think we should go all the way in that direction. We do seek inflation-like assets but I think that will be quite limited, particularly if inflation creeps up dramatically.

“We do look at what we call alternative inflation, where we use inflation linkers and project linkers, so that is an area we want to expand but it would not be sufficient. We continue to ask whether the implicit inflation instruments or more traditional asset categories have a higher return. It would be rather stupid to create your own bubble.”

With a long-term target of 6-7% per annum, this pretty much leaves conventional asset classes, in particular public equities, as the major inflation-generating instrument for a pension manager the size of APG. But non-standard, non-market-cap-weighted benchmarks will be at the core of the strategy.

“If you look at the straightforward equity market equities, they are relatively limited, so we have a wide diversification in various assets,” concludes Kemna. “And for equities, we have certainly started to move to smart beta strategies that are much more interesting for pension fund liabilities, such as the minimum volatility strategy, for example. In the traditional asset categories, we move away from traditional market indices because they are not, per se, ideal for pension liabilities.”

The FTK already placed a considerable cost on risk assets in terms of capital buffers, and the general trend in financial services regulation – be that Basel III or Solvency II – is certainly less tolerant of risk assets overall. There is also a strong debate, both in the Netherlands and in the wider EU, in the run-up to the proposed new pensions directive over the requirement for risk taking in capital markets to fund expected levels of pension versus the need for some level of security for those pension rights. Meeting the pension goals of the upcoming generation of Dutch teachers, civil servants and firefighters will not be any easier for Kemna or her successors at APG.

Ms. Kemna sounds like one sharp lady who knows what she's doing on the alpha and beta portfolio. If APG is serious about seeding emerging alpha managers that will offer them liquidity, scalability, low correlations and low beta, then I urge them to contact me so I can introduce them to talent in Canada ( LKolivakis@gmail.com). One problem, they have to allow the managers to live here as none of them speak Dutch or can easily move to Amsterdam (great city).

Below, the Greek deal is the beginning, not the end, says Greg Peters, Morgan Stanley chief cross-asset strategist, who thinks there is still a rough road ahead. Although he's not wrong about the challenges facing Greece and the eurozone, I warn investors that the biggest tail risk remains a market melt-up and those that are ill-prepared will underperform in 2012.