Diversified Growth Fund A Sophisticated Approach to Multi-Asset Investing
Introduction The Trustee of the NOW: Pensions Scheme has appointed NOW: Pensions Investment A/S Fondsmæglerselskab A/S as Investment Manager to the Trust assets. NPI is a wholly owned subsidiary of ATP in Denmark. ATP was established by the Danish Government to ensure a certain level of welfare provision for senior citizens. All Danes are required to save for their old age through the ATP scheme. ATP was established in 1964 and now ranks as one of the twenty largest pension schemes in the world. The Group now looks after more than 5 million members and manages assets of over 87 billion (31st December 2016). The investment approach and strategy of ATP s Investment Department are shared with NOW: Pensions Investments. Overview The Diversified Growth Fund (DGF) is the investment growth generating engine for members of the NOW: Pensions Trust. The DGF has a long-term investment horizon; employs efficient implementation processes; and adopts a level of investment risk which is specifically designed to generate an appropriate return for members of the Trust. The long-term horizon makes it important for the portfolio to be able to perform well in a broad variety of economic scenarios. This is achieved predominantly through effective portfolio diversification and disciplined rebalancing. Diversification is achieved by categorising assets into risk factors which display different return distributions over time. By weighting the different categories, the effect of different economic scenarios at fund level are less pronounced over a long-term horizon. Rebalancing ensures that portfolio risk remains close to the long-term target and therefore the benefits of diversification are maintained over time. While diversification and rebalancing are the key ingredients for superior risk adjusted returns, tactical tilts allow each individual risk factor to deviate from its long-term target weights. 2 NOW: Pensions Multi-Asset Investing
Investment beliefs Our investment beliefs are integral to the construction and maintenance of the portfolio. Horizon Long-term investment strategies tend to offer superior risk-adjusted returns compared with short-term investment strategies Risk Premia Risk Premia - the expected additional return for holding riskier assets - should compensate for the greater risks being taken. Individual risk premia vary over time. Holding a diversified portfolio of risk premia strategies is more efficient than trying to time individual risk premia Diversification Diversification of risk factors and sources of return provides a more stable portfolio return over the longer term. However, in the short term, correlations may become unsettled and the benefits of diversification may temporarily diminish. Markets Market inefficiencies and irrational investor behaviour can cause prices to deviate from their fundamental values. Such deviations can give rise to opportunities for alternative risk premia strategies and tactical trades Behaviour We have limited predictive power. We focus on superior management of areas where we can make a difference, such as efficient diversification and cost of implementation. The portfolio aims to perform well under different economic scenarios within the remit of a defined risk target. This leads to portfolio construction which is based on a risk contribution from different Risk factors, rather than on a traditional cash contribution. Investments can be levered up or down to deliver the necessary level of risk to contribute to the overall portfolio. Inefficiencies and behavioral biases exist within markets, and the fund capitalizes on these by investing in alternative risk premia strategies which are expected to contribute to overall investment returns in the long-run and increase the diversification of the portfolio. Short-term opportunities may also arise and be exploited as tactical tilts within the portfolio. Comparison of Asset and Risk Allocation within a Traditional Portfolio Equity Bond Asset Allocation Risk Allocation A traditional 60/40 Portfolio carries approximately 90% of its risk within the equity portfolio. The NOW: Pensions DGF addresses this concentration of risk by creating a well-diversified portfolio. Multi-Asset Investing NOW: Pensions 3
Risk Factors Portfolio diversification is achieved via a risk factor approach, which has been developed in conjunction with ATP. All assets in the portfolio are categorised as an exposure to one or more main risk factors. Diversification is achieved by maintaining well-diversified exposures within, and between the risk factors. The risk factors have been defined following an in-depth analysis of common factors demonstrated by the historical return distributions from different assets classes. The result is a set of four risk factors to which portfolio risk is attributed. Equity Factor Favourable return when global equities perform Rates Factor Favourable return when global interest rates fall Inflation Factor Favourable return properties in strong inflationary and deflationary environments Diversifying Strategies Rules based time varying strategies with diversifying properties The two dominant risk factors belong to Equity and Rates. These two risk factors contain long market risk premia which display similar return distributions over time, although with low correlation. Their respective Sharpe ratios are both close to 0.35. The Equity risk factor contains exposure to global equity markets via equity futures and to credit spreads via CDS Index positions. The Rates risk factor contains exposure to developed bond markets via bond futures and cash bonds diversified on the interest rate curve. The Inflation risk factor is intended to protect the portfolio s performance when inflation jumps higher without growth following suit - a stagflation scenario. This is an economic environment where typically, neither equities nor bonds have performed well. The long-term Sharpe ratio of the Inflation risk factor is slightly above 0, but this becomes markedly higher during periods of significant inflationary change. The Inflation risk factor contains two types of exposure. Firstly to developed break-even inflation via long cash inflation-linked bonds and short bond futures and secondly to global commodity markets. The risk factor also contains exposures which are expected to perform well in times of global deflation. The Diversifying Strategies risk factor is an aggregation of alternative risk factors aimed at diversifying the total portfolio and is made up of alternative risk premia (ARP) strategies. There are many different definitions of ARP, but within the DGF our assessment is that ARP strategies are empirically-tested sources of return that can be systematically harvested through quantitative rule-based strategies, often in a long/short format. The balanced portfolio of ARP strategies has historically had a Sharpe ratio in excess of 0.5. The Diversifying Strategies risk factor is made up of alternative risk premia (ARP) strategies. The ARP strategies implemented in the DGF diversify the total portfolio in the sense that they have a low correlation to the other risk factors which comprise classic exposures to equities, credit, rates, inflation break-even and commodities. The ARP strategies can be internally or externally managed. 4 NOW: Pensions Multi-Asset Investing
Examples of ARP strategies held in the DGF: Externally managed Emerging Market FX trend strategy: The strategy is a trend (time-series momentum) strategy of a basket of 10 Emerging Market currencies vs. the US Dollar. The strategy takes long or short positions in each of the 10 currencies, with higher conviction momentum signals translating to a larger absolute position in a given currency. In the long run, the strategy should benefit from the fact that Emerging Market currencies have a tendency to exhibit trends. Externally managed commodity trend strategy: The strategy is a trend strategy on a basket of 22 commodities. The strategy takes long or short positions in each of the 22 commodities if the absolute trend signal is higher than a pre-defined threshold. In the long run, the strategy should benefit from the fact that commodities have a tendency to exhibit trends. Internally managed betting- against beta equity strategy: The strategy is a long/short strategy on European equity sectors. The strategy is a beta-neutral strategy which takes long positions in the sectors with the lowest betas and short positions in the sectors with the highest betas. In the long run, the strategy should benefit from the fact that European equity sectors with low risk have outperformed equity sectors with high risk on a risk-adjusted basis. Externally managed multi-beta equity strategy: The strategy is a long/short strategy on single developed stocks. The strategy is designed to capture the long-term risk premia associated with the well-documented risk factors of size, momentum, value and low volatility. Stocks in scope are classified according to each risk factor. Within each risk factor the strategy takes long positions on the top 50% within the risk factor, and short positions on the MSCI developed index. In the long run, the strategy should benefit from the fact that equities with relative low volatility, high value, high momentum and low market cap have outperformed a broad equity index on a risk-adjusted basis. Review of Constituent Parts A process driven review of the constituent elements of the Equity, Rates and Inflation risk factors is conducted at least every 3 years, where the characteristics and attributes of each group of assets are evaluated and analysed. Inflation Factor Equity Factor Equity Factor Inflation Factor Interest Rate Factor Interest Rate Factor Interest Rate Factor Diversifying Strategies Communities Index Linked Bond Government Bond Corporate Bond Equity ARP strategies Expected return Multi-Asset Investing NOW: Pensions 5
Portfolio Construction To construct the portfolio, the risk factors are represented by relevant investments. Each investment must be predominantly exposed to the relevant risk factor, but additional criteria are used to determine inclusion diversification benefit; relevance to the portfolio; implementation complexity; and cost. From the representative investments, the historic return distribution for different factor risk weightings are evaluated based on long-term return potential and stability of returns. The long-term factor risk weightings (percentage of total risk) for each of the four risk factors is close to the minimum variance portfolio. Illustration of target risk exposures Diversifying Equity = 35% Rates = 35% Inflation = 15% = 15% Strategies 80% Equities 20% Credit 25% UK 25% Europe ex UK 25% US 25% Asia 50% US HY 50% EU HY 1/3 UK 1/3 Germany 1/3 US 1/3 2 yr bonds 1/3 5 yr bonds 1/3 10 yr bonds 1/3 2 yr bonds 1/3 5 yr bonds 1/3 10 yr bonds 1/3 2 yr bonds 1/3 5 yr bonds 1/3 10 yr bonds 50% Breakeven Inflation 50% Commodities 1/3 UK 1/3 Germany 1/3 US Commodity Basket Alternative Risk Premia Portfolio Process The portfolio and the intrinsic processes are separated into two areas: Core portfolio and portfolio processes The core portfolio is long market risk premia ( Equity and Rates ), has exposures which perform under large changes in inflation ( Inflation ) and takes long positions in a collection of alternative risk premia (ARP) strategies. The core portfolio is built on a risk contribution framework with asset classes allocated between the four different risk factors. The core portfolio process is designed to maintain the portfolio with fixed risk allocations to the four risk factors through systematic rebalancing. Within each risk factor individual exposures are also rebalanced systematically. Tactical Management Process A further feature of the portfolio is the tactical tilt capability, which is predominantly driven by valuation opportunities. The valuation driven tilts are based on a systematic screening of asset class valuations relative to historic valuations. The aim is to identify cheap assets which are expected to mean revert. Other ideas are also included in the TAA area. The tactical management process does not discriminate on the source of an idea, but analyses and treats each idea in an isolated, structured manner. A primary source of ideas emanates from our relationship with the ATP Investment department where investment views are exchanged on a regular basis. The TAA process aims to provide a sufficient set of information data enabling evaluation of an investment idea within the environment of the portfolio. Each idea follows a process where the risk and reward characteristics are measured against a risk adjusted return requirement in order to evaluate the expectation of added value to the portfolio. 6 NOW: Pensions Multi-Asset Investing
Risk Measure The risk measure used in the portfolio management is Expected Shortfall, where risk is measured from thousands of simulated portfolio returns. The risk within each risk factor is measured separately and risk within the four factors is used to calculate the proportion of risk attributed to each risk factor. Value at Risk (VaR) and Expected Shortfall (ES) Input and Calculation The VaR and ES are calculated by taking historical inputs such as daily fluctuations in the portfolio s instruments and correlation between different instruments. Based on this data, we simulate 10,000 3-month scenarios. The scenarios are then ranked from the best outcome to the worst. VaR - The loss in the 100th worst case scenario ES The average loss of the 100 worst case scenarios Value at Risk (VaR) As an example, if the VaR is measured at 1m, a loss of at least 1m can then be expected in one out of 100 quarters (1% probability). N.B. As 1m is the 100th worst case scenario out of 10,000 simulations, there are still 99 scenarios that are equal to or worse than 1m. Expected shortfall (ES) Closely related to VaR. Among 10,000 simulated 3-month scenarios, ES is the average loss of the 100 worst scenarios. As an example, if ES is 1m, that is the average expected loss in one out of 100 quarters Total risk VaR as a percentage of the net asset value (NAV) of the portfolio. As an example, if the NAV of the portfolio is 100m, and VaR is 10m, the total risk in the portfolio is 10%. Defining total target risk The target for the total risk is adjusted on 1st January every year. It is based on the VaR of a traditional 60% equity /40% bond strategy on 30th September in the previous year. Risk allocation Expected Shortfall in each risk factor divided by the sum of the expected shortfall in the overall portfolio. Gearing factor The relationship between the portfolio s exposure and its NAV. Example: If the value of the portfolio is 100m and we invest in futures with an exposure value of 125m, the gearing factor is 1.25 (125/100). Multi-Asset Investing NOW: Pensions 7
Portfolio Risk Level The DGF adopts a risk target level equivalent to the risk level of a 60% equity / 40% bond portfolio. This corresponds with an expected annual return volatility of between 6% and 8%. To achieve a total risk level of this magnitude in a diversified portfolio, the investments in each risk class are levered (geared) up or down to deliver the necessary levels of risk. An example of this would be the allocation to Inflation which represents 15% of total risk, but could actually require an exposure of around 50% of the portfolio value. The core portfolio is invested and managed as a sub-portfolio separated from TAA positions. The core portfolio is the main driver for returns over the long-term, and is expected to account for 80% to 90% of return variation. Example portfolio structure Graphical Illustration of risk allocation within a fully constructed portfolio. European Rates TSMOM US Equity TSMOM (500 holdings) European Equity TSMOM (60 holdings) Commodity TSMOM (22 holdings) EM FX TSMOM (10 holdings) EQ Global Betas (2095 holdings) EU CLI (50 holdings) EU BAB (271 holdings) US Rates TSMOM US Equities (500 holdings) Continental European Equities (219 holdings) Commodity Index (15 holdings) UK Equities (100 holdings) Asian Equities (2399 holdings) UK 10 year rate futures UK 5 year Gov Bond UK 2 year Gov Bond US 10 year rate futures US 5 year rate futures US 2 year rate futures European High Yield (75 holdings) US High Yield (100 holdings) European 5 year rate futures European 10 year rate futures European 2 year rate futures TSMOM Time Series Momentum / CLI Composite Leading Indicators / BAB Betting Against Beta 8 NOW: Pensions Multi-Asset Investing
Organisation Investment management services are provided by NOW: Pensions Investment A/S Fondsmæglerselskab in Denmark. The dedicated portfolio management (PM) team is headed by the Chief Investment Officer (CIO) and is responsible for the day to day execution of core portfolio processes contributions; rebalancing and other maintenance of the portfolio including funding positions and currency hedging. The majority of processes are largely rules based. The PM team also conducts valuation screening, screening of ARP strategies and shares ideas with the ATP Investment department in order to generate inspiration. The PM team performs analysis of trade ideas and makes decisions on positions at weekly portfolio meetings, although exceptional decisions can be made outside of the portfolio meeting. The team has been together since 2012, when NOW: Pensions Investment A/S was established. The back-office processing of investment instructions, risk measurement, risk and return reporting and other administrative activities is performed by support teams within ATP. The investment decision making process is independent of the decision making process within the ATP Investment department, and the PM team has full discretion to perform the investments within the parameters laid down by the Trustees of NOW: Pensions. The NOW: Pensions Investment CIO reports directly to the ATP CIO, and monthly meetings are held with the Trustees of the NOW: Pensions Scheme, enabling regular examination of the portfolio s risk & return characteristics; the costs associated with managing the assets; as well as internal and external developments. Independent Assessment Redington act as Investment Consultant to the Trustees and some of the comments from their review of the Diversified Growth Fund are reproduced below. This is a sophisticated approach to multi-asset investing. The strategy borrows from ATP s risk balanced approach which has been run since 2006. The team has been able to utilise the successful elements and apply them in a global manner. The team think deeply about portfolio construction and risk factor correlations. Particular attention is paid to volatility and stress scenarios where they use expected shortfall to measure risk. The strategy extensively utilises the ATP risk infrastructure. The risk construct adopted has a robust methodology. The allocation to diversifying strategies allocation is consistent with Redington s favoured approach of blending a mix of traditional risk premia (risk parity), alternative risk premia and trend-following exposures. Redington s Investment Committee assigned an Approved Rating to the NPI DGF and are positive on the fund. Multi-Asset Investing NOW: Pensions 9
Information correct as at November 2017 GM00191.1117/2 NOW: Pensions is a UK occupational pension plan. Membership is only available through an employer, following satisfactory checks on the employer. This is written as a general guide only. It should not be relied upon as a substitute for specific professional advice. Registered office: 2nd Floor, 25 Christopher Street, London, EC2A 2BS Registration number: 07766398. Registered in England and Wales, Scotland or Northern Ireland NOW: Pensions 2nd Floor 25 Christopher Street London EC2A 2BS Tel: +44 (0)330 100 3336 nowpensions.com