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DESPITE misguided and so far unfounded concerns, the European Organization for Nuclear Research’s (CERN) Large Hadron Collider has not created a black hole that, in turn, has swallowed earth and humanity. If it had, what the European scientific institute famous for smashing together sub-atomic particles did with its employee pension fund would be relatively meaningless. However, since we are all still here, the risk management and portfolio overall currently under way in Geneva matters—for the system’s thousands of pensioners, as well as for other capital pools willing to learn from CERN’s innovations.
First, an introduction to CERN’s team. Theodore Economou is the organization’s pension Chief Executive Officer and is potentially the nicest man in investment management. A close second for this title might be his Chief Investment Officer, Gregoire Haenni. They are the types that apologize profusely for even minor incidents of tardiness. They are exceedingly well mannered, as only two non-Americans can be. Together, they comprise the brain trust of the $4 billion pension system, and the work they are doing—focusing on portfolio reconstruction and proprietary risk modeling—is appropriately suited to an institution with multiple Nobel Prize recipients on staff.
“Essentially, what I found when I arrived in October 2009 was a very traditional portfolio that any pension CIO would recognize,” Economou says on a phone call with aiCIO following his October appearance at the aiCIO Summit in London, England. “It was 60% risk assets, including real estate, and 40% bonds. The fund did a strategic asset allocation study every three years, followed by tactical allocation moves, with the fund taking fairly large single bets, such as bets on currency.” Economou, who ran the ITT pension system in New York City before moving to Switzerland, thought it was time for a new approach. “We are in the process of changing it from this legacy, return-based approach, to a risk-based one,” he says. “It’s an absolute-return approach to the entire fund—with a key term being ‘liability-aware’.” This last term, Economou notes, means that the fund can be cognizant of its liabilities without being “slavishly tied” to liability-driven investing (LDI). “There is this religious discussion about LDI, but the reality is that it confuses actuarial losses with real cash losses,” he says. “I don’t think it’s acceptable. What this means is that, if you offset your liability with an asset, particularly a swap, if something happens to interest rates and your liability goes down, it’s great—but in an LDI world, your assets also go down the same amount.”
Hand in hand with this allocation overhaul, Economou and Chief Investment Officer Haenni also are looking to retool the fund’s risk management procedures—and this is where the truly innovative work is being done. “We look at risk management as two processes,” Economou says. “One: the overall risk management process, showing us the acceptable risk constraints. This tells us what the size of the sandbox we can play in is, and this is a process where we involve an external risk manager.” The metric presently used to measure this risk is conditional value-at-risk-based (CVar), which Economou views as “not a perfect measure, but you need to start somewhere.” (Volatility is not risk, Economou stresses time and time again; the loss of capital is the risk). The result of this first process of risk management is that the fund’s board knows whether the risks being taken lie within previously agreed upon guidelines.
The reason Haenni was hired earlier this year was not so much to create this 30,000-foot view of potential problems, but to provide an expertise in portfolio-level risk management modeling. If the first risk management process is about the size of the sandbox, Haenni’s work is about how to maximize the fun in the sandbox. “I was asking around about what the best risk management system for portfolio construction was,” Economou says. “That’s how I got in touch with him.” Haenni, it turns out, has spent his academic and professional career working on risk modeling. An extension of his PhD thesis at the University of Geneva, this model first went with him to Swiss asset manager Pictit, where he spent a decade refining the system. He now finds himself and his model in Geneva.
The model itself is a sight to behold. Its entire goal is to “illustrate risk and make it actionable,” according to Economou, by answering two questions: how manager x should behave, and how, put together, all managers behave relative to each other. The system looks at 20 dimensions of correlation that, when presented visually, are distilled into three dimensions, making it both more intuitive and easier to act upon. Once this analysis has been done, Economou and Haenni have another process they apply. “The second part is top-down, a macro-view approach,” Economou says. “We don’t pretend that we can call the market— that’s borderline delusional. People spend hundreds of millions trying to do this, and we can’t argue that we can compete with these folks, but what we can do is identify different market regimes, different areas of risk that are excessive, and we can hedge.” In essence, this two-man team is attempting to identify market regimes and position their portfolio appropriately. It’s not forecasting. It’s identifying risk.
“We refer to it as a capital preservation philosophy,” Economou notes, echoing Benjamin Graham’s mantra that to win, the first thing you have to do is not lose. “Losing money is not okay. The traditional approach of running money—the 60/40 strategic asset allocation regime we had here at CERN—is focused on performance versus an index.” There is an assumption in this framework, Economou and Haenni believe, that the index, over time, will meet a fund’s needs. “We don’t view this assumption as appropriate,” Economou adds. “Market cycles can be very long—look at Japan. And boards don’t always understand volatility.” Put another way: They are not bullish on world markets, and they’ve designed a systematic approach to investing that (they hope) will allow them to act successfully upon this belief.
Of course, Economou and Haenni can’t go it alone. Their board, as at any other pension fund, must approve changes to asset allocation and risk controls. “Our board has been superb,” Economou says, noting that an institution that draws upon more than 10 countries for funding and houses some of the brightest minds in the world will naturally produce high-quality board members. Relying on Netherlands-based consultant Ortec Finance to confirm that the new asset allocation fits within the risk scope that the board finds comfortable, the fund has been “very receptive to the changes” Economou and Haenni are implementing. Alongside spending the summer “programming liability risk—our benchmark—into the model so that any incremental manager’s risk impact can be identified,” Economou and Haenni worked hard to educate their board on the new paradigm. “It was a success,” notes Economou. “They understand, and they are happy with the ideas underlying the changes. There is a difference between ‘conservative’ and ‘traditional.’ Most boards are ‘conservative’—as they should be—but that doesn’t mean 60/40 is ‘conservative.’ Investment boards and executives need to disassociate these two terms—and ours seems to be doing this.”
The inevitable stressful periods, the team knows, are yet to come. “The real test is when markets are up 20% and we’re below that,” Economou says. “We have told the board that we look at it as ‘how much have we left on the table on the upside to protect the downside.’ I think they’ll be with us in this scenario, due to the usual mantra: education, education, education.”
This could all be for naught, of course. Similar to its pre-2009 pension structure (which, Economou stresses, wasn’t wrong— it just needed to be updated) CERN’s particle collider is running at only half power due to an explosion in 2007. Yet, by 2013, it is expected to be firing sub-atomic fragments around its 17-mile loop at nearly their full speed—after which, if skeptics are to be believed, none of us will be here to see how either experiment turns out.