Within the community of pension funds in continental Europe, The Dutch Shell Pension Fund has a particular place. More than a decade ago, the fund has left the traditional road of (overly) defensive investment strategies. Now, its asset allocation is heavily biased towards equity and international diversification. By joining the vanguard in areas such as asset-liability modelling, tactical asset allocation (TAA) and currency overlay, the fund has been able to build up an impressive buffer over the fund's liabilities of 48%.

One of the key factors in this respect has been the currency overlay programme. With the first mandate implemented at the start of 1994, the fund was among the very first European institutions entering this field. From the start the programme has been aimed at internalising relevant knowledge. Paradoxically, this was initially done by contracting several outside managers, By selecting established names and a variety of styles, the fund has built up the necessary experience in currency management. Building further on this, the first internally managed mandate was established in late 1995.

Of course, in early stages of the programme numerous hurdles had to be taken. One important element for the implementation has been the development of a stringent controls framework. For example, all transactions are settled by the fund's own back office, whether the trades were executed by external managers or for internally managed portfolios. Secondly, a segregation of front office, back office, data maintenance and performance measurement minimises any operational risk and the operating systems are tailed to reflect this infrastructure. Thirdly, clear and strict guidelines are defined in the contracts of the outside managers, including acceptable counterparties with explicit exposure limits, Finally, external audits and reviews are performed to ensure the quality of the controls.

1996 has been a major turning point for the programme, as it was then integrated into the asset liability modelling process. The asset allocation that resulted from this process was tilted even further towards internationally diversified equity (60%). The resulting increase in total fund risk was compensated by the implementation of an extended version of the currency overlay programme. On a strategic level, the plan ef-fectively shifted from (non-systematic) currency risk towards (systematic) equity exposure.

In the current mandate, a mixed mandate is used: both the US dollar and the Japanese yen have a fully hedged benchmark, whereas all other currencies have unhedged benchmarks. The hedges for the dollar and yen are partly passive, partly active. The passive hedge consists of forward contracts that are rolled over at maturity and several cash loans. As the passive hedge is always fully implemented, it only makes marginal excess performance versus its benchmark as a result of execution of roll-over swaps and due to differences in duration.

The active mandate for the dollar and yen is split up over a range of different managers. Currently, four external managers and two internally managed portfolios have mandates. Managing styles range from fundamental, pure technical to a portfolio insurance approach. Over time all portfolios have delivered considerable and quite consistent excess performance. Due to their fully hedged benchmarks, the correlation of the portfolio returns is high. However, clear differences in performance and risk appetite are visible over time.

Apart from the mandates for the dollar and yen, the fund has the possibility to hedge any currency exposure if deemed necessary by the currency committee, a multi-disciplinary team with professionals from fixed income, treasury and TAA. However, from a fund perspective tactical deviations from the currency benchmark only account for modest added value. The true performance boost lies in the strategic shift of risks, which enables the fund to use its core capacities to the outermost.

The hedge on the dollar illustrates this strategy. During the most of 1997 the dollar was in a rising regime against the deutschemark. In such an environment outperformance of the fully hedged benchmark is relatively easy. This positive excess performance was combined with a negative cash flow, as the rising dollar caused the short forward positions on the dollar to loose value. On the other hand, however, the tilt towards equity did its work by easily beating the return on the unhedged dollar.

In the long run, the combination of asset allocation and currency overlay should result in a very low probability of underfunding (negative buffer) in combination with minimal contributions from the plan sponsors. Their integration into the asset liability modelling process illustrates the pay off from the fund's strong commitment to ride the learning curve.

Contributed by the Shell Pensioenfonds Beheer in the Netherlands

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