Should Pensions Think Like Macro Funds?
CEO of the Cern Pension Fund Theodore Economou says pension funds should use the techniques of the best global macro hedge fund managers to control risk and volatility while producing absolute returns.A report on the full interview with Theodore Economou will be published in the June issue of Hedge Funds Review. Mr. Economou is very sharp and highly respected in the pension fund industry. He ranks among the top 100 influential asset managers in aiCIO's Power 100, a list which includes CEOs and CIOs of well known Canadian and international funds. aiCIO provided this profile on him:
Pension funds should use the sophisticated risk management tools used by the best hedge funds to lower volatility and achieve better returns, says Cern Pension Fund CEO Theodore Economou.
Cern invests its entire Sfr4 billion ($4.1 billion) pension fund as if it were a large global macro hedge fund. "We manage towards an absolute return target," says Economou. "We believe our model can and should be replicated by pension funds with the same goals as Cern because we think the model represents an answer to the industry's challenges."
For those funds not able to replicate the Cern model, Economou advocates turning over the entire pension fund portfolio to a top hedge fund management company.
If the hedge fund industry works together with pension funds, he believes it has the potential to grow five or 10 times larger than it is today.
Economou made the comments at the European Single Managers Awards 2013 held in London, where Cern Pension Fund was given the award for outstanding contribution to the hedge fund industry by an institution.
Earlier in a video interview he said he believes the hedge fund industry can "come to the rescue of the pension fund industry". He believes the disciplined risk management of hedge funds allows them to control risk while at the same time delivering smooth returns. "This is exactly what pension funds need to do."
Risk management combined with flexibility in allocating assets under the overall objective of preserving capital needs to be embedded in the entire process, he says.
"I believe passionately the Cern model provides an ideal response to the challenge pension funds are facing," says Economou.
The Cern governance model is designed to accommodate a dynamic and flexible asset allocation process, which Economou believes is essential in order for pension funds to avoid losses and meet returns in the long term with minimum volatility.
"The Cern process starts with addressing what really matters to trustees: what losses can be accepted; what is the investment return objective; and what are the constraints in terms of liquidity and permitted instruments? Only after setting these boundaries does the portfolio get built to meet those objectives."
Economou has taken the traditional process and "turned it on its head". "The fact is that the traditional model is failing to deliver," he says.
In his view in order for a pension fund to be more conservative it needs to be less traditional and throw out the 60%/40% stocks/bonds model.
Over the three years since Cern's switch from the traditional model to implement Economou's ideas, the fund has "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."
At 14 years of age, Economou witnessed something that would shape his approach to risk forever. In 1979, he and his family were based in Tehran, the Iranian capital, when the Shah was overthrown, prompting the Islamic Revolution. The country changed overnight and Westerners—along with many others—had to leave immediately. Panic was everywhere—except for Economou’s household.
“My father had already made plans to leave,” he says. “He had gathered information from a network of contacts, not just the official channels, and had known something was about to happen. We didn’t even miss a day of school.” The experience of an entire society changing so rapidly made him realize that it paid to be prepared for any eventuality, not just what you suspect could happen. “It doesn’t mean you have to be pessimistic—this mindset applies equally to seizing opportunities—but you need to be in a situation where you are ready and can react.”
Almost three years on from joining the CERN pension, the lessons he learned in Tehran are evident. The model he introduced to the fund in 2009—which had lost 19% of its value a year earlier—aims to manage risk, preserve capital, and achieve the highest quality absolute returns. This, of course, is a simplistic outline of what Economou, a trained engineer, presented to scientists at one of the world’s finest research organizations. “It helped to speak the same language,” he says. “I explained we were targeting efficiency and control in the same way that they were. We would just deal with investments while they dealt with fundamental particles.”As reported by aiCIO back in 2010, Cern is revolutionizing risk management:
Despite misguided and so far unfounded concerns, the European Organization for Nuclear Research's (CERN) Large Hadron Collider has not created a black hole that, in turn, has swallowed earth and humanity. If it had, what the European scientific institute famous for smashing together sub-atomic particles did with its employee pension fund would be relatively meaningless. However, since we are all still here, the risk management and portfolio overall currently under way in Geneva matters—for the system's thousands of pensioners, as well as for other capital pools willing to learn from CERN's innovations.Cern Pension Fund's latest annual information meeting 2012 is available here. As you can read, their objective is to achieve the actuarial return objective of 3% over inflation (5% long term), with the lowest possible level of risk at all times. Since 2009, they've implemented the following significant changes:
First, an introduction to CERN's team. Theodore Economou is the organization's pension Chief Executive Officer and is potentially the nicest man in investment management. A close second for this title might be his Chief Investment Officer, Gregoire Haenni. They are the types that apologize profusely for even minor incidents of tardiness. They are exceedingly well mannered, as only two non-Americans can be. Together, they comprise the brain trust of the $4 billion pension system, and the work they are doing—focusing on portfolio reconstruction and proprietary risk modeling—is appropriately suited to an institution with multiple Nobel Prize recipients on staff.
“Essentially, what I found when I arrived in October 2009 was a very traditional portfolio that any pension CIO would recognize,” Economou says on a phone call with aiCIO following his October appearance at the aiCIO Summit in London, England. “It was 60% risk assets, including real estate, and 40% bonds. The fund did a strategic asset allocation study every three years, followed by tactical allocation moves, with the fund taking fairly large single bets, such as bets on currency.” Economou, who ran the ITT pension system in New York City before moving to Switzerland, thought it was time for a new approach. “We are in the process of changing it from this legacy, return-based approach, to a risk-based one,” he says. “It's an absolute-return approach to the entire fund—with a key term being ‘liability-aware'.” This last term, Economou notes, means that the fund can be cognizant of its liabilities without being “slavishly tied” to liability-driven investing (LDI). “There is this religious discussion about LDI, but the reality is that it confuses actuarial losses with real cash losses,” he says. “I don't think it's acceptable. What this means is that, if you offset your liability with an asset, particularly a swap, if something happens to interest rates and your liability goes down, it's great—but in an LDI world, your assets also go down the same amount.”
Hand in hand with this allocation overhaul, Economou and Chief Investment Officer Haenni also are looking to retool the fund's risk management procedures—and this is where the truly innovative work is being done. “We look at risk management as two processes,” Economou says. “One: the overall risk management process, showing us the acceptable risk constraints. This tells us what the size of the sandbox we can play in is, and this is a process where we involve an external risk manager.” The metric presently used to measure this risk is conditional value-at-risk-based (CVar), which Economou views as “not a perfect measure, but you need to start somewhere.” (Volatility is not risk, Economou stresses time and time again; the loss of capital is the risk). The result of this first process of risk management is that the fund's board knows whether the risks being taken lie within previously agreed upon guidelines.
The reason Haenni was hired earlier this year was not so much to create this 30,000-foot view of potential problems, but to provide an expertise in portfolio-level risk management modeling. If the first risk management process is about the size of the sandbox, Haenni's work is about how to maximize the fun in the sandbox. “I was asking around about what the best risk management system for portfolio construction was,” Economou says. “That's how I got in touch with him.” Haenni, it turns out, has spent his academic and professional career working on risk modeling. An extension of his PhD thesis at the University of Geneva, this model first went with him to Swiss asset manager Pictit, where he spent a decade refining the system. He now finds himself and his model in Geneva.
The model itself is a sight to behold. Its entire goal is to “illustrate risk and make it actionable,” according to Economou, by answering two questions: how manager x should behave, and how, put together, all managers behave relative to each other. The system looks at 20 dimensions of correlation that, when presented visually, are distilled into three dimensions, making it both more intuitive and easier to act upon. Once this analysis has been done, Economou and Haenni have another process they apply. “The second part is top-down, a macro-view approach,” Economou says. “We don't pretend that we can call the market— that's borderline delusional. People spend hundreds of millions trying to do this, and we can't argue that we can compete with these folks, but what we can do is identify different market regimes, different areas of risk that are excessive, and we can hedge.” In essence, this two-man team is attempting to identify market regimes and position their portfolio appropriately. It's not forecasting. It's identifying risk.
“We refer to it as a capital preservation philosophy,” Economou notes, echoing Benjamin Graham's mantra that to win, the first thing you have to do is not lose. “Losing money is not okay. The traditional approach of running money—the 60/40 strategic asset allocation regime we had here at CERN—is focused on performance versus an index.” There is an assumption in this framework, Economou and Haenni believe, that the index, over time, will meet a fund's needs. “We don't view this assumption as appropriate,” Economou adds. “Market cycles can be very long—look at Japan. And boards don't always understand volatility.” Put another way: They are not bullish on world markets, and they've designed a systematic approach to investing that (they hope) will allow them to act successfully upon this belief.
Of course, Economou and Haenni can't go it alone. Their board, as at any other pension fund, must approve changes to asset allocation and risk controls. “Our board has been superb,” Economou says, noting that an institution that draws upon more than 10 countries for funding and houses some of the brightest minds in the world will naturally produce high-quality board members. Relying on Netherlands-based consultant Ortec Finance to confirm that the new asset allocation fits within the risk scope that the board finds comfortable, the fund has been “very receptive to the changes” Economou and Haenni are implementing. Alongside spending the summer “programming liability risk—our benchmark—into the model so that any incremental manager's risk impact can be identified,” Economou and Haenni worked hard to educate their board on the new paradigm. “It was a success,” notes Economou. “They understand, and they are happy with the ideas underlying the changes. There is a difference between ‘conservative’ and ‘traditional.’ Most boards are ‘conservative'—as they should be—but that doesn't mean 60/40 is ‘conservative.’ Investment boards and executives need to disassociate these two terms—and ours seems to be doing this.”
The inevitable stressful periods, the team knows, are yet to come. “The real test is when markets are up 20% and we're below that,” Economou says. “We have told the board that we look at it as ‘how much have we left on the table on the upside to protect the downside.’ I think they'll be with us in this scenario, due to the usual mantra: education, education, education.”
This could all be for naught, of course. Similar to its pre-2009 pension structure (which, Economou stresses, wasn't wrong— it just needed to be updated) CERN's particle collider is running at only half power due to an explosion in 2007. Yet, by 2013, it is expected to be firing sub-atomic fragments around its 17-mile loop at nearly their full speed—after which, if skeptics are to be believed, none of us will be here to see how either experiment turns out.
- Reduced equities, replacing with alternatives
- Increased bonds, reducing cash
- Reduced index strategies, replacing with asymmetric strategies
- Reduction of risk of real-estate portfolio
In my blog, I cover various approaches different pension funds use. HOOPP did it again last year, gaining 17% in 2012. HOOPP's president and CEO, Jim Keohane, told me that they run their fund like a multi-strategy hedge fund and their culture and LDI approach are the cornerstone of their success. They manage assets internally, practice tight risk management and they're always thinking outside the box, taking intelligent risks like their long-term option strategy on the S&P 500 which paid off handsomely in 2012.
Ontario Teachers' Pension Plan gained 13% in 2012. They manage absolute return strategies internally but also have a large allocation to external hedge funds. Ron Mock, who will succeed Jim Leech as President and CEO in 2014, is running one of the world's best funds of hedge funds at Teachers and heading their fixed income operations. Ron knows absolute return strategies better than most of the best hedge fund managers and I gurantee you he will be working closely with top global macro and multi-strategy hedge funds to reduce volatility and increase returns. At Teachers, they don't just invest in hedge funds and private equity funds, they leverage these relationships significantly to improve their overall returns.
CPPIB gained 10% in FY 2013 and the Caisse de dépôt gained 9.6% in 2012. Canada's two largest pension funds engage in absolute return strategies internally and are big investors in external hedge funds, including top global macro funds. They are also very active in private markets, heavily investing in private equity, real estate and infrastructure. The shift to private markets is their strategy to lower volatility and increase returns at their funds.
But increasing allocations to private markets means locking up funds for many years and smaller pension funds do not have the resources or liquidity profile of a CPPIB or PSP Investments, which recently bought Hochtief's airports unit, and can't take on more illiquidity risk. Even large funds like Ontario Teachers' and the Caisse have to manage liquidity risk more carefully after the 2008 crisis. Teachers shifted most of their hedge funds to a managed account platform and are managing liquidity risk a lot tighter after the crisis.
Getting back to global macro hedge funds, their performance has been surprisingly poor given the influence of macroeconomic and political events on all asset classes since the financial crisis, but as RoRo becomes less dominant, global macro strategies could return to form in 2013.
When it comes to hedge funds and private equity funds, choose your partners carefully, and this doesn't always mean investing with the big brand names. Often times it's worth cultivating relationships with small or mid-sized funds with established track records where you can work more closely with senior managers to improve your internal processes at your pension fund.
Mr. Economou's idea of farming out the entire pension fund portfolio to a top hedge fund company if you cannot adopt the Cern governance model might sound extreme, but as pension funds struggle to obtain their actuarial target return relying on the traditional 60/40 stocks/bonds model, this approach is worth considering. Most underfunded mature pension plans simply cannot afford to relive another 2008, it will kill them. The focus has to shift to tighter risk management and bringing risk awareness back in the process.
Below, Theodore Economou, CEO of the Cern Pension Fund, discusses why pension funds should use the techniques of the best global macro hedge fund managers to control risk and volatility while producing absolute returns. Great interview, well worth listening to his comments.