Sitting above the Large Hadron Collider, CERN pension chief Théodore Economou turned an outmoded legacy, return-based approach to investing into a dynamic risk-based one. Now he’s on a mission to spread his ideas across the investment world.
In a 1950s-style office at the end of a long, slightly claustrophobic corridor that could easily pass for any school or college in the world, sits the pension chief of the European Centre for Nuclear Research, Théodore Economou.
Geneva’s CERN laboratory is famous worldwide for its discoveries in ‘new physics’ and in particular the Large Hadron Collider, which brings thousands of students every year to its door. What is perhaps less well known is that over the past five years, Economou and his close-knit team have created a new type of pension fund now known in global institutional pension circles simply as the CERN model. This has been the trigger for a different sort of pilgrimage, as a number of the largest pension funds from Canada to the Netherlands to Australia, have beaten a path to his door to find out about the CERN way of running assets.
Economou recently announced he is moving on, but his work at CERN is likely to define his future career. ‘When I arrived here, I inherited a traditional 60/40 pension model working on a three-year asset allocation cycle. It had become obvious to the board that it was not helping to achieve its objectives.’
His first move was to build a close team to execute the dramatic overhaul of the fund. Existing CERN employees Elena Manola-Bonthond and Alberto Desirelli were made head of strategic planning and risk respectively, and Economou recruited Nicolas Salomon and Alexandre Rosetta as head of middle office and internal portfolio management respectively.
‘Alberto is a terrific quants specialist, while Elena is excellent at looking at the bigger picture. Alexandre has long-term experience as a fund manager, while Nicolas is a great operations guy.'
A fifth member, Gregoire Haenni, was drafted in as CIO on a fixed contract but left at the end of 2013. He has now taken up a role as head of investments at Geneva Canton’s pension fund.
Economou is clearly pleased for Haenni and says the move is testament to the work that he and the team have achieved at CERN. While the chance of the world disappearing into a black hole was enough for CERN to be sued unsuccessfully in Germany a few years ago, the centre is now building an even larger, 88km long collider tunnel 100 metres underground in its search for the particles that created the universe.
What the litigious German observers will do about this potentially even bigger threat to the world is uncertain, but Economou is enthused about the project and its potential to once again turn conventional scientific thinking on its head. While he may not have quite attracted the headlines afforded to the laboratory, this is exactly what he what has done to institutional pension fund management.
Rethinking pension model convention
Fifteen years ago, the average pension fund was a long book of equity with a smaller amount of fixed income to offset the risk. A decade ago, Economou says, hedge funds were added to offset costs, while the seismic events of 2008 jolted many pension fund CIOs – and the broader asset management industry – to reappraise the role of alternative assets.
‘In 2008, a lot of alternatives worked as expected, but most pension funds did not have enough of them. Now CIOs also have to contend with absolute levels of fees, which is a new restraint, so we think a liquid, factor-based portfolio to capture traditional beta while benefiting from adding alternatives to capture idiosyncratic alpha is the way forward.’
Economou wants to spread the word across the institutional world that his risk-based approach is the way to go. He is ‘honoured’ by the awards the fund has won, and the high profile of the often far bigger pension fund investors who come to learn. About 10% of the team’s time is taken up with acting as an educational establishment.
‘It is very much a part of our mission. It was a natural step that Lombard Odier asked me to chair its investment committee.
‘My ambition is to spread the gospel, to help other pension funds to get better risk-adjusted returns. It could be helping an investment advisory firm to buy the best technology, or sharing our multi-asset approach, whether on hedge funds or private equity.
‘What is terrific about people reaching out to us is that we CIOs all grapple with the same challenges.
‘Where we have been first is in building riskdriven models with absolute risk target levels and we are at the forefront of the multi-asset factorbased model, but what we have done is not yet the accepted model.’
Economou’s overhaul of what was a bog standard 60/40% equity/bond pension model into a risk-based model with a number of uncorrelated alpha generating assets is now complete and he will not stand for re-election when his contract expires next year. Economou conceives the approach as something akin to a global macro hedge fund strategy, where alternatives play a key role. ‘It is about integrating the portfolio to get the most bang for your buck for the least possible risk taken.
This often leads to misconceptions that the pension fund simply follows a low-risk strategy. ‘People sometimes say we run a low-risk strategy. This is simply not the case. We have a high-efficiency strategy to get you to your objective with the least amount of risk.’
The CHF 4.2 billion model has created its own ripples across the institutional world and brought its Swiss Greek chief plenty of plaudits along the way. Key to it all is a forensic approach to risk profiling that the scientists who monitor the safety of the Large Hadron Collider would be proud of.
Economou has devoted the past five years to finding truly uncorrelated, or as he would call it, ‘idiosyncratic’ assets for his fund, and in doing so, also embraced the world of alternatives.
That he has done it while easily beating the trustees’ cash plus 3% target, and with significantly less volatility than the market is something of which he is evidently proud. ‘What we have done is provided an answer to all the CIOs out there who want to achieve the best return possible for the least risk at all times. That is the fundamental change we have made.’
Not that he is likely to ever get complacent in an environment where the political and economic backdrop is forever shifting. ‘A CIO’s challenge today is managing risk with increasing uncertainty, and in public pensions, you have to do it under very strong scrutiny of fees.
‘What I have achieved is first, a governance structure that is riskdriven within a given risk budget and second; risk has been integrated into the institutional portfolio.’
Such an overhaul required what Economou terms a ‘leap of faith’ from the board of trustees and the acquisition of high-end technology to achieve the aim. Economou had to focus on what he calls the big levers first.
Number one was implementing the risk management side and second was getting the board of trustees to allow him the freedom to employ the assets he desired. Only after that, was the 60/40 equity and fixed income portion of the portfolio overhauled.
The last part of the jigsaw was integrating a private equity portfolio and having run a CHF 1.5 billion private equity portfolio for a US Fortune 500 company in a previous job, it seemed obvious that Economou would eventually turn to an area in which he could gain what he calls ‘truly idiosyncratic alpha’.
‘It was a deliberate choice to focus on the big levers first so it was not the right time internally to bring the private equity in.’
The private equity component is now being ratcheted up, with Economou working closely with US private markets specialist StepStone, which runs over $60 billion of private capital allocations and has $10 billion of assets under management.
‘By working alongside StepStone, we can leverage their global infrastructure of 15,000 funds and 100 staff worldwide.'
The CERN team speak regularly with StepStone’s London-based CIO David Jeffrey to build a custom-made private equity programme. ‘We have one analyst here overseeing the relationship and this gives us access to a secondaries market with much lower fees than a fund of funds.’
With the deal put in place 18 months ago, Economou can react very fast if a buyer comes to market. Since the start of 2014, the fund has been able to buy into seven or eight private companies ranging from software firm DivX, a key part of Sony’s Xbox capabilities, to Greater China infrastructure play Megcif and a US specialist midcap buyout vehicle.
‘These are not big amounts – around CHF 4-5 million – but we need a lot of small bets when we are looking for truly idiosyncratic returns.
‘Often we can buy these companies at significant discounts to NAV from a seller that needs to clean up their balance sheet. Speed is very important when you are trying to buy alpha so working with StepStone’s network means we can often move within two weeks.’
Elsewhere, Economou has built a long-only hedge strategy with Two Sigma, a leading-edge player in institutional investment management.
‘They are a company with 300 PhDs, so it is a good cultural fit with us. They were willing to build a product to combine a long-only beta element with a timing (macro) and alpha element. The result is a risk-managed equity strategy.’
His next move could take him anywhere in the world. But he says he will always remain proud of the job he has done at CERN.
‘I am very grateful that I have been allowed to develop the CERN model. We are at an organisation where the core mission is to advance the frontiers of science so it is always a big test for your intellect.’
Spotlight on the CERN portfolio
Some 25% of the fund is invested in equities. The gross exposure is closer to 20% owing to the beta exposure, and includes index strategies, risk-managed strategies and specialist equities.
In June, the team cut exposure by 7% from 32%, because of heightened macro uncertainties. Fixed income accounts for 27% of the portfolio, primarily in a mix of government and investment grade corporate bonds. The holdings are generally at the short end of the curve and Economou has been trimming the credit exposure to keep volatility down and maintain sufficient liquidity. Around 12% of the portfolio is in cash.
About 15% of the fund is in a prime commercial property portfolio in London, Paris, Milan and Berlin, and a residential portfolio in Geneva.
Economou says the Berlin transaction has just been completed. ‘It was complicated, but we were willing to take the time to get it done. We have done little in MBS yet, as it takes time to get regulatory and board approval to restructure the mandate. Structured products were given a lower priority.’
Economou has also looked at the New York property market but has decided against it for now as the team does not have the expertise on the ground.
Approximately 15% of the fund is in hedge fund-like vehicles that can use a full array of tools to give the smoothest line to the target return.
While Economou says real estate is likely to grow, he says that pure alternatives are not, owing to the pressure on keeping fees down. About 3% of the fund is in private equity and there is a key focus on the secondaries market. The team use global private markets specialist StepStone to buy companies on the secondaries market at big discounts to NAV. Economou says: ‘Private equity offers uncorrelated alpha not accessible in the public markets. To access it, you can build a team, which is expensive, or you can go down the fund of funds route. We went half way by partnering with StepStone.’
Economou is very selective about investing in infrastructure. ‘We think there are better returns on offer with other sorts of illiquid strategies. We like bond-like infrastructure with government backing because these are illiquid assets so you need to be very selective. We like Tunisian airports, but this is not for everyone. The question is always: Are you compensated for the illiquidity premium? We have absolute return targets and have to be brutal around illiquidity premiums. A road bond might give us 40 basis points above sovereigns. That might delight the CIO of an insurance firm, but it is not enough for us.’