Steady performance through asymmetric returns

Victoria-Volksbanken Pensionskassen has tried to move away from the traditional Austrian pension plan model. David White speaks to Claudio Gligo, who is responsible for the plan’s investments, about meeting members’ risk aversion

Not always among the leaders, but never among the losers. That might be the motto of Austria’s €460m Victoria-Volksbanken Pensionskassen (VVP), a multi-employer Austrian pension fund based in Vienna.

Since it was set up in 1990, the fund has pursued an innovative strategy of generating asymmetric returns - that is, avoiding the downside while trying to capture, as far as possible, the upside. This strategy has met with success, producing an aggregate performance, since inception, of 6.5% annually.

The VVP has developed as a hybrid of defined contribution (DC) and defined benefit (DB) schemes. The DB element exists for historic reasons, since some of the companies that are contracted with the VVP scheme have brought existing DB arrangements with them. In these arrangements, employers guarantee to make up the difference between the return target set and the target achieved.

However, most arrangements are DC, funded by employer and employee contributions. The schemes have to meet annual return targets if they are to keep pension payments stable. These targets are known as the ‘calculatory return’ which employers set when they establish pension schemes for their employees.

VVP believes that the generation of asymmetric returns is the best way to ensure that the calculatory return is met. The asymmetric return strategy has been developed by a team at Volksbank AG, a major shareholder (47.5%) of VVP, which has overall management of the fund’s assets.

VVP takes a multi-manager approach to the management of its assets. Assets are invested through both mutual (pooled) funds and special (segregated) accounts. As a general rule, equities have tended to be managed through mutual funds and fixed income securities through special accounts. Yet this rule can be broken - if, for example, equity assets are large enough to justify a segregated account.

The fund uses a three-layer screening process to select its managers. The first layer is a quantitative process, designed to identify consistent performance and outperformance. The second layer is a qualitative screen, based on responses to questionnaires. The third layer involves personal meetings with managers and on-site visits.

Although VVP outsources the management of the full spectrum of asset classes, it retains control of what it regards as the core functions of a pension fund - asset allocation and risk management.

Claudio Gligo, head of institutional asset management at Volksbank AG and the board member responsible for the investments of the VVP, explains: “We regard a sound understanding of the characteristics, drivers and risk/return profile of each asset class as the key for long-term success in the financial markets. Therefore, the main focus must be on a thorough fundamental asset class analysis and the assessment of inherent risk.”

The investment process is designed to produce a return profile similar to a call option, he says. “The downside can be limited during periods of market weakness without giving up the potential for upside when markets are more benign.”

The linked process of asset class analysis and risk management enables VVP it to identify asset classes which will generate asymmetric returns. Convertible bonds are a prime example of such an asset class, says Gligo: “Convertibles have an asymmetric return profile because of the way they are constructed - a bond with a call option on equities.

“When equities tend to rise convertibles will rise as well and your participation in the positive returns will increase too. Conversely, if equities tend to fall, your participation in negative outcomes tends to fall too. So you could say that convertibles provide a kind of automatic rebalancing.” VVP set up convertible bonds as separate strategic asset class in 2006 and has appointed two managers to run it.

“Convertibles are a very complex asset class, and we have had to pay considerable attention to the selection of fund managers with the necessary expertise,” says Gligo. “There are not many specialist managers who understand all these factors and can construct a good portfolio.”

In addition, alternative investments provide a useful tool for the generation of asymmetric returns, he says. “Alternatives are one of the best examples of asset classes that can generate asymmetric returns because investors in alternatives are looking for absolute returns and pay no attention to a benchmark.”

The choice of alternative will depend on the type of portfolio, he says. “In portfolios with higher equity allocations we tend to have more volatile directional strategies focused on absolute returns. In portfolios which are focused more on capital preservation we tend to have lower volatility strategies, such as arbitrage and credit strategies.”

VVP’s investment process has also helped it to identify asset classes to avoid, Gligo says. One of these is asset-backed securities (ABS). “Two or three years ago, everyone was searching for extra yield, and many invested in strategies such as ABS. What they neglected to analyse was the risk/return profile. It’s very dangerous to be invested in an asset class like ABS if you don’t get paid extra for the risk factors involved, because there is a huge downside. In the case of ABS, investors were getting money market, or below money market, performance for no extra income. Another market phenomenon we considered as highly questionable was the increased use of structured credit vehicles in institutional investors’ portfolios.”

VVP has taken a similarly bearish view of high yielding credits. “In the first part of 2007, which was very bullish for risky asset classes like high yield, we did not have these asset classes in our portfolio. Our analysis told us that we weren’t getting paid enough for the risk inherent in these assets classes,” says Gligo.

Since 2007, in the wake of the sub-prime crisis, and the subsequent credit crunch, spreads have widened and the rewards of high yield bonds have increased. “In the first half of the year the reward was about 2%. Now the reward for these securities is 8% above treasuries,” Gligo points out.

This may represent a buying opportunity for VVP, he says. “As an opportunistic investor, we could start to look at these asset classes now because the risk premium is above the historic average. We would now get some reward for bearing the higher risk and this could be beneficial for the longer term performance of the fund.

“So a thorough understanding of the performance drivers and risk factors for each asset class is highly relevant. Asset managers have to know how different asset classes behave in different scenarios. If we don’t understand how an asset class behaves in different scenarios we won’t invest.

“The important thing is not to be a momentum investor. Our approach enables us to be more opportunistic because dislocations in markets create opportunities and you begin to get paid for the extra risk.”

 

Asset class analysis is only one half of the equation in the search for asymmetric returns.The analysis has to be linked to a system of risk management.

Risk management at VVP operates at several levels. At the single fund level, style mix, consistency and benchmark deviation are checked, while at the portfolio level, performance, diversification, correlations and deviations from the strategic asset allocation are evaluated and monitored.

On top of this, the pension fund’s overall risk profile is checked each day to ensure it complies with its risk tolerance. “It is very important in times like these that risk management is a rigorous and ongoing process. It’s not once a month or once a week but every day,” says Gligo.

VVP has set up an independently organised risk unit which provides portfolio managers with daily information about the current use of pre-defined risk budgets.

It has also built a risk management system which uses a variety of models - notably VaR and Monte Carlo simulations. “We have adopted a multiple approach because we think that one model cannot capture all risk factors,” says Gligo. “We think that our risk management approach is comparable to international and state of the art standards.”

Once a risk indicator moves into ‘red’ territory, he says, a risk meeting immediately takes place to evaluate the drivers of risk.

The pension fund has overall responsibility for the strategic asset allocation, says Gligo. “Equity allocations are defined but usually we have some leeway to deviate from this strategic asset allocation. So if the strategic asset allocation is 40% equities, traditionally we could go from 30% to 50%.

Risk management can extend these limits if necessary, he says. “If we have to hedge out more than 10% of equities we must be able to do so because otherwise the risk management function cannot succeed.”

In the fixed income area, asset allocation decisions are made by the team at Volksbank AG. “There are different sub-asset classes to consider - government bonds, high yield bonds, emerging markets bonds - so we need to have flexibility to apply our dynamic, non buy-and-hold portfolio management approach.”

VVP manages eight different portfolios, with different strategic asset allocations according to the liability profile and risk tolerance. The allocation to equities for example, ranges from 5% to 40%, depending on the type of portfolio.

This range of portfolios is designed to provide investment choice within the pension fund. VVP has tried to move away from the traditional ‘one size fits all’ pension plan common in Austria to something that more closely matches the risk tolerance of the membership.

The VVP lifecycle model offers three portfolios - conservative, balanced and aggressive. One of the restrictions stipulated by the regulator is that a move is only possible from a risky portfolio to a less risky one, not in the other direction.

“VVP’s maxim is to avoid severe drawdown by not being exposed to overpriced assets. This means that we do not uncritically follow investment trends just because of recent price behaviour. Long-term oriented investors like pension funds should not become too involved in fashions, but should keep their eye on the fundamentals. If the result of your analysis is that you don’t get the right risk premium - hands off!

“As our analysis revealed assets that were overpriced at an early stage, this approach has paid off in recent market conditions.”