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Dutch treatise

If you want something done right, do it yourself.

If you want something done right, do it yourself.

So goes the thinking at the Netherlands' ABP, Europe's biggest pension fund. Created in 1922 for Dutch civil servants -- employees and retirees from education, central government, military, police, judiciary, municipal authorities, provincial authorities, water and energy -- ABP manages more than three quarters of its E150 billion ($147 billion) in assets in-house. That sets it apart from the vast majority of the world's pension funds, which outsource the money management function.

Internal fund management was a no-brainer back when the fund was a mere arm of the state. For most of its life, ABP was restricted by a special law to the safest possible backyard investments: Dutch government bonds, Dutch real estate and Dutch municipal loans. But even after the fund was privatized in 1996 and its investment guidelines liberalized, chairman John Neervens and chief investment officer Jean Frijns decided to buck conventional wisdom and stick to in-house management rather than take the outsourcing path. Along with one or two other big pension funds and a handful of industry experts, they believe internal management delivers investment decisions that meet pension clients' needs better than outside suppliers possibly can.

"We have chosen to keep most of the management of the money in-house, because we think it is the best governance structure and allows us to react quickly to changes in markets," sums up Frijns.

Conventional wisdom, of course, holds that outsourcing is more cost-efficient. Pension funds can't pay the kinds of salaries top fund managers command, and most decide that the expertise of outsiders is well worth paying a fee for. And if a particular external manager doesn't measure up, there are plenty more where he came from.

Swimming against the tide, in the six years since privatization, Frijns has more than doubled the number of fund managers and analysts working for ABP Investments, as the money management business is called. He has radically diversified its asset mix, boosting a formerly anemic exposure to equities and venturing into alternative investments, from hedge funds to commodities. Equities now make up 40 percent of ABP's investments, up from 14 percent in 1996. Its exposure to alternative investments, including hedge funds, private equity and commodities, is among the largest of any pension fund in the world, at 20 percent. ABP is now even debating whether to let its internal equity managers short stocks.

The company has no intention of running money for third parties and still outsources the management of its more arcane investments as well as its growing U.S. allocation. Nevertheless, partnering with PGGM, another big Dutch pension player, ABP has assembled a stable of niche firms to bring in-house expertise in such fields as private equity and structured products. And it has implemented a risk budgeting strategy designed to protect its members' money in a low-return environment. This all adds up to a level of inventiveness and daring rarely seen in pension funds. "There is a real commercial feel about ABP these days," says David Mitchell, client executive in the financial institutions team at J.P. Morgan Chase & Co.'s investor services division.

Equally improbable for a fund that used to be little more than a dreary backwater of the Dutch state, ABP has become a leader in shareholder activism. Mainly through initiating motions at annual meetings, ABP is taking aim at Dutch companies that have two-tier voting structures, such as financial services company ING Groep, food manufacturer Koninklijke Numico and temporary employment services provider Vedior. And its presence is being felt. At Numico management has promised to abolish two-tier voting within a couple of years. "We want to be in the forefront of promoting international standards of corporate governance in the Netherlands," says the fund's chief counsel, René Maatman.

Governance is a recurring theme when ABP's top brass explain their rationale for managing money in-house. Outsourcing, they feel, directs a pension fund's energy and resources toward the product their suppliers sell -- returns. In-house management, by contrast, focuses attention on how best to meet liabilities, which is what the fund's customers really care about.

"In my experience too many money management firms put the needs of the business ahead of the needs of the investment environment and the needs of the clients," says Jan Straatman, who runs ABP's E70 billion global equities portfolio. "ABP has shown an eagerness to transform itself into a professional money manager and a willingness to innovate. That flexibility should stand the fund in good stead."

Outsiders also think ABP's in-house approach serves clients' interests well in a scary investment environment. "Running money internally does sharpen the focus of a pension fund on its liabilities," says Ronald Liesching, head of research at Pareto Partners, a $30 billion currency overlay and fixed-income manager in London. And Keith Ambachtsheer, founder and president of consulting firm KPA Advisory Services in Toronto and an expert on pension fund governance, puts ABP in the vanguard of a small group of public pension funds that could change the money management industry. "What ABP [is] doing is a new model of pension fund management and one that presents a tremendous competitive challenge to the investment management industry," he says.

So far, the in-house strategy has delivered results. ABP boosted its equity position in time to catch much of the bull market ride of the late 1990s -- but because it never loaded up on stocks to the degree that U.S., U.K. or even other Dutch funds did, it outperformed last year. In 2001, when the Standard & Poor's 500 index dropped 13 percent and the MSCI Europe index fell 21 percent, ABP beat the WM universe of Dutch pension funds (a Deutsche Bank Group­owned index that measures the aggregate performance of the country's pension funds), with a ­0.7 percent return versus the index's ­2.8 percent. ABP also outperformed rival asset pools last year, beating the California Public Employees' Retirement System's ­11 percent return on $142 billion in assets and the ­3.5 percent performance of U.K. insurer Prudential's $130 billion main life fund.

But a lot is riding on ABP's model. Pension funds the world over must cope with the twin pressures of people living longer and a bulge in liabilities as baby boomers retire. The end of the bull market in equities, coupled with historically low interest rates, have compounded these problems into a global crisis. "The low-return environment is the biggest topic of conversation for pension funds around the world," says Maarten Nederlof, global head of pension strategy for Deutsche Asset Management in New York. "In the past 12 months, I visited probably 100 different funds in 30 countries, and I can tell you that they are all concerned."

ABP is no exception. Its cover ratio -- the relationship of assets to members' current and future pension rights -- fell from 117 percent last year to 112 percent now. To make matters worse, ABP's liabilities are linked to its members' inflation-indexed wages, and in 2001 Dutch inflation stood at 5.1 percent, double the European average. Though forecast to fall to 3.6 percent this year, it remains stubbornly high compared with the rest of the euro zone, largely because of wage pressures due to relatively high employment. "We are in a squeeze between low returns on the asset side and high rates of inflation on the liability side of our balance sheet," acknowledges Frijns.

Last year ABP's nine constituents, or "sections," representing some 2 million people, gave ABP Investments their seal of approval, voting to remain members rather than starting their own pension plans. (The vote was mandated by the government as a condition of the fund's privatization so that its constituents would have a chance to bail out if they were unhappy after five years.) They could change their minds at any time -- although it would be an administrative nightmare for one member group to separate and withdraw its assets.

Besides its constituents, the fund must please ABP's board of governors, which holds ultimate executive power. This board has six representatives each from members' employers and employees and is chaired by Elco Brinkman, former leader of the Christian Democratic Appeal party, who acts as a disinterested consensus builder between workers and bosses. If investment performance falters, the board of governors could end Frijns's experiment. "The governing board could fire the people working at ABP Investments, liquidate the division and hire external money managers to do the job," says chief counsel Maatman.

The other body that could step in if the fund has performance or solvency problems is the Pension and Insurance Supervisory Authority, the government agency that is ABP's external regulator. Should ABP's cover ratio fall below 100 percent, the regulator can require that it increase contributions from its sections or cut benefits. That, too, could rile constituents and force Frijns to rethink the in-house approach.

That strategy has inherent pluses and minuses. Proponents argue that in-house management makes pension funds more accountable to their clients, since a pension fund can't explain away poor performance by pointing the finger at a vendor. That's how Leo de Bever, senior vice president of research and economics at Canada's largest internally managed pension fund, the $46 billion Ontario Teachers' Pension Plan Board, defends the similar strategy his fund follows. "In the U.S. and the U.K., most pension funds hire a consultant to give them an asset mix and another consultant to find the fund managers to implement it," he says. "When something goes wrong, the pension fund fires the fund managers or the consultants or both. It's an exercise in blame diversion."

In-house management also arguably eliminates a conflict of interest inherent in the outsourcing model. An external fund manager specializing in, say, large-cap growth stocks has an incentive to flog his specialty regardless of what the market is doing.

An analysis of U.K. pension funds last year by WM Co. praised the in-house approach. "A significantly reduced level of fees makes internal management a very economical method," the study reported. "Internally managed funds have a distinct advantage of being able to take a longer-term view. They generally have an excellent working relationship with trustees and don't have the short-term commercial pressures of externally managed funds."

But the drawbacks of internal management are considerable, too. For one thing, benchmarking is difficult -- particularly where cost-efficiency is concerned. Frijns says that ABP Investments hired an external consulting firm (a source says it was Bain & Co., though neither Bain nor ABP will confirm this) in 1999 and again this year to audit its expenses and fees; he says the conclusion was that ABP delivers good value for its clients.

Another problem is getting and keeping top-level managers. Ridding ABP of its bureaucratic culture will take generational change -- Frijns, Neervens and Jelle Mensonides, head of alternative investments, all joined the fund when it was an arm of the government. ABP is one of the world's oldest occupational pension funds (in the U.S. the Teachers Insurance & Annuity Association dates back to 1919) and is one of the few that lumps all civil servants together. Until 1996 the Dutch Ministry of Internal Affairs appointed all of ABP's board members. The company has recently given ABP Investments a separate headquarters and compensation scale. But it still can't compete with top New York or London salaries. "The problem ABP and any in-house-managed fund faces is attracting talent," says Pareto Partners' Liesching. "Taking a deep breath and paying market levels of remuneration is never going to be easy."

Nevertheless, pension consultant Ambachtsheer is convinced not only that ABP will weather the current tough economic conditions but also that it will set an example for pension funds everywhere. "I call funds like ABP the new Simbas of the investment world," he says. "They are the Lion Kings, right at the top of the food chain. In the past 25 years, fund managers have been on top. But now pension funds are taking their rightful place."

If ABP can demonstrate that in-house management is cheaper than outsourcing for constituents, while delivering superior results, it may just send a wake-up call to pension funds around the world. And it could shake up traditional relationships between pension funds and their hired guns, be they consultants or money managers.

WHEN FRIJNS JOINED ABP IN 1988, HE WAS hamstrung by regulation. Since its inception, the fund had been governed by a special law, the General Civil Pensions Act, whose diktats were inimical to good investment sense. ABP was obliged to put one third of all contributions into Dutch government debt and was almost completely barred from investing outside the Netherlands. Thus by the 1990s one of the world's largest pension funds had 95 percent of its assets invested domestically (mostly in bonds and loans; it was by far the biggest buyer of Dutch debt) and next to nothing in the U.S., an economy 30 times the size of ABP's home market.

Neervens, who was CEO of the Amsterdam-based Social Fund for the Building Industry until the government picked him to run ABP, pushed the politicians in the Hague for change. At the same time, Frijns embarked on a public relations campaign, explaining the benefits of a liberalized investment regime to ABP members through the Dutch press. Both were unusual courses of action in consensus-based Dutch society, where criticism of the status quo, especially as it regarded the state, generally takes place behind closed doors.

The double-barreled attack worked -- with help from two external factors. First, the Netherlands economy, like most others in Europe, slumped in the early 1990s. Budget deficits ballooned, and Dutch politicians realized that shifting the pension burden to the private sector would be a smart move. Second, in preparation for European monetary union, the Maastricht Treaty, ratified in 1993, barred governments from forcing financial institutions to buy domestic debt.

After ABP won full independence from the Dutch government, the fund had more investment freedom than ever. But at that point, ABP's cover ratio had dropped to 106 percent. So Frijns overhauled ABP's asset allocation, boosting its equity exposure beyond even where most peers, immune from the General Civil Pensions Act, were invested. In 1996 ABP had 80 percent of its assets in fixed income, mainly Dutch government bonds, bank debt and municipal loans. Equities, again mostly Dutch, made up just 14 percent of total assets. The remaining 6 percent was in real estate. By 2000 Frijns had changed the mix to 53 percent fixed income, 40 percent equities and 7 percent real estate. Its current target allocation is 60 percent stocks and real estate, with the balance in fixed income.

Frijns's timing was good: Thanks to the bull market, ABP's cover ratio rose to 130 percent by the end of 1999. And from 1996 to 2001, ABP's returns matched those of the WM universe -- impressive given that it was building its equity position during a rising market when peers already had significant commitments to stocks.

Today ABP Investments manages more money than the fund subsidiary of Holland's largest bank, ABN Amro Holding, or the country's largest institutional money manager, Robeco Groep. Yet Frijns calls the creation of a professional money management business a work in progress, and he is trying to make ABP Investments a more attractive place to work -- in part by distancing it from the benefits company, Stichting Pensioenfonds ABP, which is based in the small town of Heerlen near the German border. He has relocated ABP Investments' headquarters to a flashy new building near Amsterdam's Schiphol airport. "We are trying to build a strong investment firm," says Frijns. "Being part of a large administrative organization based in Heerlen did not help."

With ABP Investments managing most of the core portfolio -- mainstream bonds and equities -- Frijns is looking for ways to bolster the fund's expertise in credit investing, structured products and private equity. So ABP has formed a 50-50 joint venture with PGGM, the Netherlands' second-biggest pension fund, which has E55 billion in assets and covers health care workers. (Its CIO, Roderick Munsters, is an old friend of Frijns.) The new company, NIB Capital, headquartered in the Hague and employing 764 people, offers midmarket investment banking services and private equity and credit investment management. In 2001 it made a profit of E105 million and distributed E50 million in dividends to its joint owners. ABP won't disclose NIB's performance returns.

The joint venture has three business units, organized from three acquisitions that ABP and PGGM made together. In 1999 the two funds paid E2 billion for De Nationale Investeringsbank, a medium-size, Hague-based bank with expertise in asset-based securities and other structured products. Along with De Nationale came E1 billion in private equity investments that the bank had made for itself. Then, in January 2000, the two funds spent E820 million on venture capital firm Alpinvest Holding, based in Naarden and Utrecht. A month later they added the Benelux region's largest corporate advisory firm, the Van den Boom Group, based in Nieuwegein.

These businesses have been renamed under the NIB umbrella and serve as a diversification play for their owners. NIB Capital Bank is an investment bank concentrating on middle-market companies in Benelux. (To minimize conflicts of interest, no one from ABP or PGGM sits on NIB Capital Bank's board.) NIB Capital Asset Management specializes in European corporate credit, loan and structured products such as asset- and mortgage-backed securities; it manages E20.5 billion for ABP. Beginning in October NIB Capital Asset Management will be incorporated into ABP Investments.

NIB Capital Private Equity, a venture capital firm, invests in Europe, the U.S. and Asia. It has E14.5 billion in committed capital, E7 billion from PGGM and E6.5 billion from ABP, plus its own E1 billion portfolio.

Says Frijns: "The main rationale was to buy expertise in private equity and credit products. At the same time, we bought some assets worth having. The banking business of NIB should be a source of income and offers diversification with our core investment strategies."

Besides branching out into new investment vehicles, ABP Investments has been building up its core equity and bond management teams internally. ABP's contacts with Dutch universities (both Frijns and research chief Tom Steenkamp are part-time finance professors at the Free University of Amsterdam) have helped the fund lure young academics. Attracting seasoned professionals with market savvy is another story. Frijns says hiring is a priority: ABP Investments' staff has increased from 195 in 1999 to 325 today (ten of them have Ph.D.s). Of the total, 53 are senior portfolio managers and 110 are junior fund managers or analysts. About half of the investment managers are recent university graduates.

Frijns's biggest disadvantage is getting investment managers to work for public sector salaries, so ABP's compensation structure is also being overhauled. "What we have tried to do is stress the uniqueness of ABP Investments within ABP, and that has included trying to get our people remuneration closer to the market rate for investment professionals than to the pay scales of Dutch civil servants," says Frijns. "We now have our own remuneration structure and bonus plans."

One important hire came in September 2001, when Straatman signed on as chief investment officer for ABP's global equities portfolio. He had been chief investment officer of Achmea Global Investors, the $50 billion fund management subsidiary of Benelux insurer Eureko, which also owns London-based F&C Management (the former Foreign & Colonial Management). He has reorganized ABP's equity management process, which formerly relied heavily on quantitative analysis, and says he is developing a more fundamental, bottom-up strategy to complement the quant work. He has also abandoned regional teams. ABP now has three global equity port-folios, each with a different investment style and separate management: a quant team, a sector-rotation team and a sector-neutral, fundamental stock-picking team.

Straatman is also attempting to lengthen the holding period of investments beyond the three to six months typical for quant-based asset management, especially for the fundamental team. "We think there is a competitive advantage that we have as a pension fund, in that we can take a longer time horizon than many fund managers who are under greater short-term pressure to deliver performance," he says.

In this environment new kinds of supplier relationships have evolved. Take State Street Corp., one of ABP's global custodians since the mid-1990s and a provider of indexed fund management. A subsidiary of State Street, Princeton Financial Systems, supplies the Dutch fund with its trading and accounting systems. In February 2001 ABP and State Street inked a joint venture called State Street Global Alliance, whose brief is to make investments in niche asset management companies.

Frijns says the partnership has three aims. First, it's an investment in an industry he thinks will yield good returns in the long term. Second, he gets to meet a new crop of money managers who might otherwise not be on ABP's radar. (For example, ABP recently gave a $100 million U.S. large-cap quant mandate to Advanced Investment Technology, a Global Alliance manager based in Clearwater, Florida.) Third, Frijns hopes to import into ABP Investments some knowledge about how entrepreneurial money managers are run.

State Street officials say the joint venture differentiates ABP from other pension fund clients. "We think of our relationship with ABP as a partnership that is based around identifying where we can offer solutions and pool resources," says John Snow, vice chairman of State Street Global Advisors, which is second in Institutional Investor's ranking of the largest U.S. money managers. "That is different from knocking on a client's door and trying to shift product."

THE BIGGEST PRESSURE ON FRIJNS THESE DAYS comes from the rotten markets. To cope with them, since 2000 ABP has employed a technique known as risk budgeting, managed by former head of active and foreign fixed income Thijs Coenen, who has been with ABP for 14 years. Like every pension fund, ABP has assets (its investments and contributions) and liabilities (the current and future claims of members and pensioners). Risk budgeting is designed to create the optimal asset mix to meet these liabilities, what ABP calls a "norm" portfolio. The norm portfolio is set annually; for 2002 the target mix is 52 percent equities, 40 percent fixed income and 8 percent real estate.

But with ABP's cover ratio at 112 percent, volatility of more than 12 percent would pose the risk of liabilities outrunning assets. So, under the risk budgeting plan, target volatility for overall returns is 10 percent. To limit volatility and improve returns, ABP uses a process called strategic alpha allocation -- basically, putting money into asset classes that should generate returns higher than the norm portfolio over time.

In the strategic alpha portfolio, the investment mix is 40 percent equities, 40 percent fixed income and the remaining 20 percent -- that's E30 billion -- alternative investments: 9 percent real estate, 5 percent private equity, 2 percent commodities, 3 percent hedge funds and 1 percent inflation-linked bonds. (A typical Dutch pension fund has no alternative investments at all; CalPERS has 5 percent of its assets in hedge funds.) Such assets generally have relatively low correlation with the norm portfolio, so they reduce risk through diversification.

For the same reason, in real estate ABP has been repositioning its portfolio away from direct investments in the Netherlands. In July 2001 it sold a 38 percent interest in its wholly owned residential property fund, Vesteda Management, to local institutions including ING Property, raising E1 billion. It intends to further reduce its stake to 25 percent. It also plans to reduce its holding in retail property fund Corio from 39 percent to 25 percent.

To run its hedge fund allocation, ABP has turned to fund-of-funds managers. It has appointed two managers and expects to hire three more, although alternative investments head Mensonides won't reveal names. In the longer term ABP has ambitions to put together a team of hedge fund analysts based in New York so it can build its own hedge fund portfolios. ABP's commodity and index-linked bond positions are designed as an inflation hedge as well as a source of diversification.

Coenen stresses that his risk-budgeting initiative has to show tangible results, not just look good on paper. "It is fair to say that at ABP we love elegant theory," he admits. "But the greatest challenge is combining theory and practice." Early evidence is that risk budgeting is helping ABP's performance: The fund comfortably beat its Dutch peers in 2001, the first full year the technique was implemented. "ABP is not afraid to embrace the new and innovative," says Pareto Partners' Liesching. "But it doesn't jump on any passing bandwagon. The staff understands the latest finance theory at the deepest level and develops what is relevant."

More important, with its focus on liabilities and without the time-consuming drama of vetting, hiring and firing outside money managers, ABP is challenging what some people think are bedrocks of pension fund culture.