Dutch regulator seeks portfolio assessments
Central bank mulls program monitoring pension funds' alternatives investments
By Thao Hua | March 4, 2013
The Dutch central bank wants pension funds to invest in alternatives with eyes wide open.
To that end, De Nederlandsche Bank — which regulates Dutch occupational pension funds — is considering a program, initially involving about 10 pension funds, in which funds complete a self-assessment of their alternatives portfolio, focusing on private equity and hedge funds.
The longer-term plan would then be to roll this out to the rest of the industry — for all pension funds with relevant alternatives portfolio, according to information provided by the DNB.
The regulator's planned pilot program follows a 12-page letter in June 2012 to provide all pension funds with general guidance and to promote the development of good practices for alternatives portfolios — among the first regulatory agencies worldwide to do so with such scale and detail.
The proposal asks pension funds to consider four areas: investment policy; selection and assessment procedures; monitoring; and governance.
“Smaller pension funds are already stretched as it is, and many can't afford to dedicate any more resources to their governance budget in order to invest in alternatives. Some are considering moving out of alternatives altogether in order to avoid differences with the regulator,” said Jelle Beenen, Amsterdam-based head of investment consulting in the Benelux region at Mercer.
“Larger funds will probably increase their governance budget because they want to continue adding alternatives,” Mr. Beenen said. However, even among larger funds, some are “simplifying their investment portfolios” to add transparency, as encouraged by the DNB, he added.
“We expect pension funds to be in control of their (alternatives) portfolio,” according to a statement from the DNB. “They need to be prudent in terms of how they invest at a very high level. We're much more explicit in terms of the level of awareness that pension funds should have with regards to the key risk drivers around the portfolio. ... If they outsource, they still need to exercise control.”
Within the e917 billion ($1.2 trillion) Dutch pensions market, the average allocation to private equity is about 4.5% of total assets, according to Dec. 31 data provided by the DNB. The average allocation to hedge funds is about 2.9%.
One of the most drastic reductions in alternatives among Dutch pension funds so far occurred at the e32 billion Pensioenfonds van de Metalektro, which halved its alternatives portfolio to 4% last year. A separate strategy investing in infrastructure and direct real estate also was reduced - to 7% as of Dec. 31, from 8% of total assets the previous year, according to data provided by PME.
PME, which in 2011 lost a court battle over the DNB's instructions to reduce portfolio risk, stopped investing in hedge funds altogether and is reconsidering other alternative allocations.
At the end of the second quarter last year, PME asked 26 hedge fund managers to liquidate their positions after an internal assessment because of “the cost involved, lack of transparency and too few opportunities to enhance control,” all of which “wasn't in proportion to the value added,” said Arno van den Heuvel, senior strategist at PME, Schiphol, Netherlands. Mr. van den Heuvel declined to name managers.
The hedge fund strategy had accounted for about 3.3% of total assets as of Dec. 31, 2011. The remainder of the alternatives portfolio is invested in asset classes such as private equity and commodities.
Since 2010, PME also has been adding internal investment capabilities to strengthen the pension board's ability to have a complete, overall view and to independently monitor the investment portfolio, which is externally managed by fiduciary manager Mn Services. The team comprises one head of investments and two senior strategists, including Mr. van den Heuvel. “One of the aims is to mitigate risk,” Mr. van den Heuvel said.
“The team is in charge of double-checking the due diligence (performed by Mn Services), analyzing strategies and reviewing the information behind investment proposals,” Mr. van den Heuvel said. As a result of the DNB's guidelines, Dutch pension funds investing in alternatives will require “more people to do the due diligence, explaining to the board how the strategies work and monitoring the investments afterward,” he added.
The campaign to impose stricter oversight of pension investment portfolios heightened following the financial crisis. Since 2009, the DNB has researched a specific area of pension asset management each year, and published guidance in relation to the research. In 2011, alternatives were the focus. The resulting guidance letter in 2012 covered asset classes including hedge funds, private equity, infrastructure, timberland, life settlements and microcredit. It was based on in-depth surveys of 35 pension funds.
Unlike previous years, however, the DNB went beyond issuing guidance to embark on a follow-up project to consider requiring self-assessments from all pension funds investing in alternatives.
After the initial self-assessment, pension funds might be asked to update the self-assessment report periodically to verify performance as relevant to the risk characteristics of the investment portfolio. Funds should also regularly monitor external money managers, including any changes in operational structures, strategy, staffing and asset valuation process, according to the DNB.
“Pension funds aren't restricted in how they invest, but they will have to substantiate” reasons for investing in alternatives, according to a statement from the DNB.
Detailed strategy lacking
Research conducted by the DNB revealed that many pension funds “lacked a sufficiently detailed strategy” and “the added value of (alternative investments) in the portfolio is not always sufficiently substantiated and justified,” according to the DNB letter. Combined with a cost structure that might not be proportional to the added value, the result could lead to “an overestimation of diversification benefits and underestimation of specific risk characteristics such as tail risk and liquidity risk.”
Therefore, the DNB will require a higher level of thorough and critical analysis conducted “in a clear, structured and transparent manner” of the alternative assets within the investment portfolio, the letter said.
Fund executives and trustees are asked not only to determine that the alternative investments are prudent relative to the risk-return profile of the fund, but also whether “the management fees are in proportion to the value added,” according to the letter. Trustees also need to make sure “there is sufficient expertise and capacity” within the pension fund to implement and monitor the strategies.
This article originally appeared in the March 4, 2013 print issue as, "Dutch regulator seeks portfolio assessments".