Beta: genuinely active management

The topic of new business models for asset management occupies many hours of discussion between institutional investors. Focusing on activities with the most added value and defining clear responsibilities aligned with a transparent investment process is a clear trend in asset management. PGGM is an investor that got around doing it. In 2006, we staged a major overhaul of our investment process. We concluded the obvious in asset management: the classical paradigm of investing along asset lines does not seem to uphold anymore. The choice of asset class is almost secondary; to maximise investment returns we have to concentrate on integral portfolio management.

Our current investment process captures this trend. We separated alpha from beta for the liquid asset classes: equities, fixed income, inflation linked and commodities. Active management at PGGM is no longer tied to assets that also play a role in capturing market returns (beta). This removes selection constraints and broadens the opportunity set for a diversified alpha portfolio. Beta management focuses on the efficient implementation of beta exposure.

Each portfolio manager brings
a different skill set: some specialise in generating alpha, others specialise in optimising beta. We've had to overcome a lot of administrative issues- it's far easier to split alpha and beta on a flip-over sheet than in a portfolio management system - but the results so far are compelling.

One of the strong points to come out of the alpha-beta separation is returning beta exposure back to the centre-stage where it belongs. Typically 90% of the return of a pension fund is determined by the ALM mix and by the choice of beta. Besides the choice of beta, the actual implementation of beta is also a challenging part of the whole process. Getting your beta management right is critical for a good risk-controlled return and deserves more focus. At PGGM, the emphasis on this process has been energised by the alpha-beta separation and the results from buying and selling cost-efficient beta exposures are promising.

Beta management at PGGM seeks to deliver close performance relative to PGGM´s strategic benchmark in a risk-controlled and value added manner. Our beta department manages €60bn, roughly 75% of PGGM's portfolio. In-depth understanding of risk is critical to success in beta management. Risk must be measured and controlled at all times. An outsider usually interprets this as fully replicating the benchmark. True words a decade ago, but beta management has progressed dramatically since then. For large institutional investors, there are far more efficient ways to replicate the benchmark (figure 1).

At the heart of PGGM's beta management lies the Sophisticated Matching Approach (SMA), an in-house developed beta management style for our global multi asset class beta portfolio that balances risk, costs and flexibility for the required beta exposure (figure 2). This approach to beta management provides a better net risk/return outcome to investors than full replication of the benchmark. Before explaining this style, we highlight the principles that form the basis for our SMA style: innovation, PGGM's edge, and integral portfolio management.

It's our belief that there is never just one way to implement beta. Investors are becoming more sophisticated in developing and implementing efficient beta products. Product innovation will continue and we want to exploit this development.

Unbundling of risk allows us to develop tailor-made beta solutions. The set of opportunities will continue to expand. We are geared to find those alternatives. More new products will become part of our beta management toolkit. Recently, we have engaged in buying beta exposure from external alpha managers not related to PGGM, which are in the process of transforming themselves to long-short managers. The opportunity set increases if we take our long time horizon into account. We can buy beta in private placements and earn the illiquidity premium.

We are a large institutional investor and are in a sweet spot to take advantage of scale economies. We realise low transaction costs. Economies of scope are also a crucial prerequisite. The beta department integrates several disciplines, sharing fixed income knowledge and products with equities, allowing us to generate new ideas that traditional beta managers might find more difficult to implement. Equally important, our multidisciplinary team has the ability to source new ideas to set up the required exposure that we need. We have a strong network. Being a large long term institutional investor certainly helps in exploiting the set of opportunities.

Integral portfolio management. Here, we drill down PGGM's investment philosophy to the core. We manage the various underlying beta portfolios integrally. We have one relative Value at Risk budget for the aggregated beta portfolio. This gives us flexibility to manage our portfolio far more efficient than if we would manage all the underlying portfolios in isolation. In certain markets reducing the tracking error to zero can be very costly. Our approach recognises that there are also cost/benefit trade-offs regarding where to reduce the tracking error in the portfolio.

Pure indexing is the lowest risk approach to index management versus a specific benchmark. However, often such an approach is very difficult to accomplish and very costly to implement. We set up the beta management department in 2006. One of the major efforts was to develop our own beta management style based on the three principles: beta innovation, PGGM's edge and integral portfolio management. PGGM's Sophisticated Matching Approach (SMA) integrates these principles.

To ensure the maintenance of close performance relative to the strategic benchmark, SMA matches the primary risk factors of the beta portfolio. However, we actively seek to add value to the fund. Therefore, in constructing the beta portfolio we make a trade-off between three factors: risk, costs and flexibility. Sometimes we are prepared to accept more risk in order to realize cost savings and sometimes we are prepared to pay more costs in order to be more flexible. This trade-off plays an important role at three levels (figure 3).

Allocation (level 1) focuses on the portfolio allocation over the various submarkets of PGGM´s strategic benchmark. For Replication, we distinguish between instrument selection (level 2) and security selection (level 3). Instrument selection at the second level determines the instruments used for replicating submarkets exposure: eg cash index portfolios, futures, options, total return swaps, ETFs and private placements. We are constantly looking for efficient implementation opportunities across all possible instruments.

Security selection at the third level selects securities used for replicating the cash index portfolios. We are looking for a balance between low tracking error and low total costs. There is a point where the falling cost of risk is balanced by the rising costs of implementation and management.

As a beta manager, we do not actively seek to generate alpha. However, the trade-off between risk, costs and flexibility at the three levels is also evaluated through focused research and market views. This approach enables us to construct a portfolio which is expected to track the benchmark closely and add value with very low risk. During trading, transaction costs are minimised through the sourcing of prices from multiple brokers and selecting the best price. Wherever possible, electronic trading platforms are used to facilitate this process. We use proprietary risk management tools as well as external tools such as Lehman Point, FactSet, Northfield and Risk Manager in the portfolio management process.

Over time, more investors will pursue the move towards separate management of alpha and beta. Investment insights will be reflected through pure alpha strategies and the beta specialist will ensure close performance relative to the benchmark in a risk-controlled and value added manner.

We continue to seek new efficient ways to implement our strategic benchmark, sourcing and implementing innovative instruments and strategies that provide us with low-cost access to market returns. One of the areas that we are currently reviewing is our equity portfolio. This portfolio is to a large extent still managed on a full replication basis but we strongly believe that an optimisation within our SMA style is more efficient. The move towards pure alpha provides impulses for the further development of beta management at PGGM. Facilitating portable alpha strategies will become more important. Also, efficient beta replication of the more exotic markets is a challenge. We are currently more than one year down the road in our new business model, and results are promising, and so is the work ahead. At PGGM's beta department we strive for being in the forefront of global beta management. This requires a constant process of innovation, review and re-engineering. The race for efficient beta has just begun.