As of 1 January this year we launched a new strategic investment policy. We believe in running a risk/return investment policy based on asset management rather than an insurance concept. The liabilities side of the balance sheet does play an important part in our policy and we will take it even more strictly into account in determining our new portfolio structure. While we do expect interest rates will move slightly upwards from the current levels, which will take some weight from our liabilities, we do not see that as a major factor. We feel our success mainly depends on an effective
investment policy that is aimed at maximising high absolute real returns.
When a pension fund formulates a new strategic investment plan it is highly recommended to take into account its own position and the environment in which it operates. We have no reasons to be dissatisfied. After the difficult years from 2000 through 2002 we easily met our 7% nominal return target. The graph belows shows the long-term ABP returns.
Our funding ratio has improved a great deal and it is our aim to reach a real funding ratio of more than 100% (which compares to around 140% nominal) again by the end of the year. This is a level which would coincide with offering the pension beneficiaries full indexation.
Although it is much criticised ‘at home', the Dutch pension system is as solid as a rock and it can still be seen as one of the most successful pension systems of the world. For instance, the system is considered to be strong enough to bear the costs generated by the ageing of the population.
In the greater part of the world the full funding of pension liabilities has only just started gaining ground. Also a full blown use of an asset liability management concept remains scarce, and many pension funds are still nothing but asset managers, sometimes subject to a number of investment restrictions.
t the same time there are quite a few challenges to be faced. The present Dutch system is in part based on solidarity, a feature of great value which we should seek to preserve. But the discussion about the adequate pension contract for the present century is now taking place, with much vigour. And it is likely that in the end this will also entail consequences for the investment policy.
A favourable starting point is also offered by our field of operation: the world economy. We currently are in a situation of dynamic capitalism. Healthy, moderate economic growth in all continents, with a bit of extra thrust from the emerging markets, is going hand in hand with a very moderate inflation trend.
In our view it is due to globalisation and productivity growth that this sunny climate will persist.
The most important threat that can be perceived is probably the need to safeguard the energy supply for future generations. Fossil fuel resources are limited and in order to prevent further global warming, our future energy supply will have to be more efficient and more sustainable. That requires the investment of enormous amounts of money. Investing in that new clean infrastructure is one of the things that we want to emphasise in our new investment policy.
There are pension funds that opt for ‘taking on insurance' to cover their liabilities. We do not do so. We do make use of interest and inflation derivatives, partially for the implementation of our strategic investment policy.
But we will continue to run a large nominal interest mismatch between assets and liabilities, because we
interpret our fiduciary duty as implying the obligation to achieve the highest possible real returns while running acceptable risks. We do not shy away from risks if we have a clear picture of those risks. After all, we expect that in the long term we will be rewarded for our risk taking.
Liability driven investment can aptly be compared with a product that comes with a guarantee. Buyers of that type of product give up a portion of upside return potential because of the costs of the insurance contract. From the viewpoint of the investor there is nothing wrong with that, and it is dependent on one's risk tolerance. But as professionals it is our job to take well-considered risks and to make sure that we are rewarded.
That is the reason why in our investment policy the search for absolute return is key. Within our organisation we have specialists whose main task relates to the securing of that beta in the long term. And there we do not restrict ourselves solely to ‘off the shelf' markets.
We think that our position enables us to realise investments at attractive costs in alternative betas, such as liquidity, volatility, and reinsurance risk markets. Don't we believe in alpha anymore? Yes, we think that markets are not fully efficient. But it is becoming increasingly difficult to add value due to a lead in terms of information supply, quality of analysis and arbitrage strategies. Efficient realisation of market exposure to the full range of investment categories is therefore our main aim.
One reason why we can afford to take risks is that like no other player in the business we can benefit from diversification. It means for instance we have increased our interest in emerging markets.
Looking back on the good results achieved on the stock exchanges of emerging markets in recent years, we see opportunities in particular in more illiquid investments in those countries, such as real estate, private equity and infrastructure. Even in the category of absolute return strategies we are awarding more mandates for emerging markets.
In addition to our involvement in emerging markets we are going to build up a worldwide infrastructure portfolio and expand our interests in private equity and absolute return strategies by a few per cent.
In our quest for return we are also shifting part of our portfolio from fixed income to real assets. We look for real investment categories that offer an attractive compensation for inflation and an attractive additional return on top of that. In addition to this we believe in active allocation between the assets, looking for value. Since mean reversion can be expected to occur in the medium term, undervalued assets will recover.
hile we do raise the duration of our fixed income portfolio we do not believe in complete duration matching of assets and liabilities. In spite of scientific efforts in that direction we think there is no sense in determining the duration of an equity portfolio for instance. After all, you may for instance come up with any figure between 0 and 20. Moreover, among other things because of the longevity risk, the duration of the liabilities is of course also a shifting quantity.
The investment world is dynamic. We are therefore constantly looking for new investment opportunities. When we find any it is our aim to pick them up as soon as possible, because we are convinced that there is a premium to be earned by ‘early movers'. In view of this we encourage our staff to come up with innovative ideas and have allocated resources (people, budget and a broad mandate) to promote and pursue innovation. We see new opportunities for instance in investing in infrastructure, clean energy, timber or patents on drugs for diseases related to old age. This could provide an excellent hedge for longevity risk.
One change that we will make as part of our strategic investment planis to divide the portfolio into two parts: one aimed at making high real returns in the long run by taking risks and another with a more defensive stance, with investments aimed at inflation-plus returns and a lower volatility. Ideally those investments should be geared to Dutch wage inflation. In practice, we will of course define the universe for this portfolio on a wider basis. In the first instance this split-up is only meant as a conceptual framework and to provide a second, alternative way of looking at the portfolio, not just in terms of investment categories. In the longer term it may develop into a management structure for the portfolio.
We are convinced that taking into account environmental, social and corporate governance factors into the decision making on investments pays off in terms of return.
However, we are now taking a next step on this path in the sense that we are integrating extra-financial factors in our investment analysis and portfolio management for all investment categories, starting with equities in 2007.
By way of conclusion we would like to highlight our people and the culture within which we operate, together constituting probably the most important factor in this overview.
Roderick Munsters is CIO at ABP and Ronald Wuijster is head of strategy and research at ABP Investments
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