Written by European Pensions team
Chair: Jesper Kirstein - CEO, Kirstein Finance
René Mogens Christoffersen - global head of client management, Danske Capital
Mads Gosvig - CIO, NOW:Pensions
Billyana Kuncheva - CFA, director of fixed income for the Nordic region, M&G Investments
Per Künow - managing director, Nordic institutional sales, MFS Investment Management
Michael Saaby Wendt - business leader, Mercer Investments Denmark
Chair: In my view we are facing a lot of different challenges, both for the asset management industry and for investors. We have seen a low yielding environment; how are investors addressing this? We are seeing a strong regulatory environment with increased capital requirements; how are investors addressing this? We are seeing somewhat higher volatility in some areas; how are investors addressing this? So the environment is challenging, but it might also be promising. What I would like to start out with is how do you see the balance between the challenges, the difficulties, the low yielding environment and the opportunities in this particular market?
Gosvig: I think the main challenge that we see is basically the low real rates that we experience in order to deliver a decent pension product for our members. So, how to organise the investments, how to organise the products in order to deliver a product that can work reasonably well within this framework. That’s one of the biggest challenges.
Chair: So how are you trying to address the challenge of low yields, high volatility?
Gosvig: Our approach has been to move away from just having exposure to growth assets and gain exposure to a broader set of risk factors, so that our portfolio will also see a return in low growth scenarios, so that we are protected against that type of risk. So we have changed our portfolio into a risk class portfolio, and we are much more exposed now to not just equities but also credit, to inflation-linked assets, to commodities and also to interest rates.
Chair: If we turn to the asset managers, what are your clients demanding from you in this particular environment, and what are you telling your clients or investors in terms of how they should navigate this very challenging environment?
Kuncheva: Obviously our clients see the same problems that every-body sees, albeit that in Finland, as a eurozone member, the macro-economic backdrop is more challenging since we have fewer intervention tools on a national level. The institutions I talk with are being forced into higher yielding assets, which as with all herding markets might cause problems down the line. Another observation is that with the benefit of the experience of 2008, some institutions have become more sensitive to liquidity issues in terms of asset class liquidity, market liquidity, and the structure of the investment vehicle.
In addition, institutions are forced to become more tactical in their views, and in the face of various investment restrictions they imple-ment them using more complex strategies, using more OTC and exchange-traded derivatives, out-sourcing structures where they don’t have the right skills, and keeping in-house the strategies where they feel they can compete themselves.
What we’ve been doing for years at M&G is we have avoided taking huge directional bets in general - we cannot quantify and analyse what Mrs Merkel is going to say next week or the week after, or what the Spanish Prime Minister is going to say in his press conference. What we tell our clients though is that they have to be aware of the correct price for risk - to analyse the risks they are taking in each asset class and find the price which compensates them for that amount of risk.
Kunow: I concur that the eurozone crisis and the lack of global growth is pushing investors towards finding better investment opportunities and seeking higher yield. Within the fixed income space we see opportunities where investors with a broader remit, than only considering investment grade or only high yield should consider the crossover space - as one opportunity. I do think investors have moved into high yield in a quite strong way, but the problem is you have ‘high yield tourists’ coming into the asset class who are not necessarily used to the kind of volatility that we have experienced throughout part of this year. In emerging market debt we continue to find valuation attractive. Then, from an equity perspective, we have noticed that investors continue to show interest for European equities as an option. I think if you compare European equities, for instance, with US equities, they have strongly underperformed in local terms, and therefore I think there are a lot of opportunities in this area. As a firm we look at the fundamentals and concentrate our focus on determining the individual stock risk, the sustainability of companies with above average growth and return and whose prospects are not reflected in their valuation. Companies with attributes likes these, we believe will outperform over the long run, without deliberatly targeting European domiciled companies. This is where we have seen inter-esting investment opportunities.
Chair: Just on European equity, in an environment where you’ve still got a European crisis, how are clients reacting? Are they with-drawing funds?
Christoffersen: I would say from the Nordic area, investors are not in general moving out of European equities, but I wouldn’t say they are flocking into the asset class either. If you look a bit outside the Nordic area, investors are definitely moving into European equities again.
Chair: Why is that? What’s the argument in favour of Europe right now? Do they believe that the crisis is over? Do they believe that valuation is so attractive?
Christoffersen: I think it’s about valuation, and also the search for a running yield, and high dividend stocks are mainly from Europe. We have an actively managed European high dividend product which has seen demand from European investors and not least from investors located outside of Europe. If you look at the performance of high dividend stocks in general in Europe this year, the high dividend stocks have just had an index retrun of around 6 per cent, so if you had a passive high dividend product you wouldn’t have performed very well. Looking at credits in general, everyone’s been squeezing into this asset class. Investors moving into this asset class now are late comers.
We have seen yields on credit move down and spreads contract, while European equities have been significantly underperforming so a move in to European equities could be next.
Wendt: It should be said that the Danish investors have actually been to a certain extent ahead of most other institutional investors around the world. They have actually been exposed to credit for many years, much more than you have seen for example historically in Sweden, and because of that I would say that they have had quite sophisticated fixed income portfolios, quite diversified portfolios in the fixed income area. But we are talking more about how to construct a portfolio in fixed income, particularly in credit, by diversifying the portfolio as much as possible. Specifically in investment grade we would like them to have as little turnover as possible in the externally managed strategy and we would therefore prefer a buy and maintain strategy. In high yields, we still see allocations to that, and the strategies are active and we find it fine if it includes allocations to senior debt. We would combine high yield and investment grade with strategies in emerging market debt, bank loans, opportunistic credit and securitised credit, and split the investments between all the different pockets in respect of the individual investor’s risk appetite. I think also that has to some extent been the development for at least some investors in Denmark.
If we look at the equity side, it’s been a trend for many years that all investors in all of Europe have been allocating less to equities. It has of course happened in the UK, where the allocations to equities have been pretty high compared to Danish investors, but we have actually seen that the trend has been against equities, not surprisingly, and all the portfolios are being more globalised so they don’t have as large a domestic allocation as they did five or six years ago.
Of course in Denmark the domestic equity market is highly influenced by very few companies, maybe that’s also why we, to a higher extent, have globalised the portfolios before they did in Sweden and other bigger countries. But regarding the equity portfolio, we have been more concerned about advising clients to play the game in the two-speed world, and allocations to emerging market equities have been favoured. We also advise them to have an option to allocate specifically to small cap and then we have a core satellite with allocations to developed markets. Finally we have a defensive part that acts as an offset to the growth tilt from allocations to emerging markets and small cap. The purpose of that is, among other things, to reduce risk of the total portfolio and to help the portfolio in falling markets.
In addition, we have seen greater allocations and greater demand for advice in alternatives; in particular there have been a lot of questions about infrastructure investments. We have seen a lot of questions in the private debt area, especially mezzanine debt and direct lending to start with, but also in other areas like infrastructure debt and real estate debt. I would think that investors are a bit more interested in real estate debt in some of the other Nordic countries, but time will show.
Chair: ATP for one has had pretty low exposure to listed stocks. Can you explain a little bit about the rationale behind that and whether you are looking to change that?
Gosvig: The ATP portfolio has been built over many years - ATP has been around for 45 years and we used to be mainly exposed to Danish assets, so we have quite a large legacy portfolio of Danish equities and we have a skilled team that runs that very well. Our non-Danish exposures are basically split into global equities, which are listed equities, and into private equity investments that we run. For the moment the main part of the foreign portfolio is in private equity and the reason is basically that it’s much more difficult to get out of private equity than it is to get out of listed equities, so it is the illiquidity of that portfolio that has made it bigger than it should be in the perfect scenario.
Chair: Are you all seeing investors move out of equities and into other asset classes?
Kuncheva: Equities have become a hated asset class and, more specifically, listed European equities have been rather unfashionable. When thinking about big waves of investments, in 2010 we saw a switch from European sovereigns into European investment grade, and then in 2011 there was a huge wave of assets that went into global high yield, and of course this year has seen a huge growth story for European high yield. These huge waves become a problem because when the mood swings you need to be ahead of the others to make sure that your exit strategy works.
Chair: What about credit? Is that a story from yesterday?
Kuncheva: We are seeing a lot of demand for specialist credit – often neglected asset classes, which require a lot analysis and due diligence work. Some, like ABS, are quite liquid, in others the story is that you get paid for the illiquidity. As an example, we all know that European high yield bonds, though theoretically a daily liquidity asset class, are not the most liquid place to be – yet you don’t get compensated for the liquidity risk. So getting explicitly paid for the illiquidity, getting the high running yield, these are things that you can find in specialist credit.
Kunow: I think one example is the continued investments which PensionDanmark (and others alike) has made into so-called infra-structure debt and property. I think this is probably something we’ll see more of because we have European banks that need to offload these loans while improving their balance sheets. This can generate even 100 basis points more in extra yield compared to ordinary listed corporate bonds, so I think there’s an argument for having a look at these opportunities.
Chair: One thing going on is that you are seeing more investors going into direct investments in areas where they did not operate before. One example could be direct lending, the taking of bank loans in some structures. Another example could be infrastructure, where we have seen a number of direct investments into windmill parks etc. What’s your attitude towards investors now being bankers, project managers, windmill experts?
Gosvig: Our approach to this is that we are not windmill experts, so we make sure that we have the right expertise whenever we do something in a new space. We get some special help or a manager to help us with it. Our direct investments in infrastructure, for example, have been done as a co-operation where we buy into a fund and then we co-invest with the fund so we have a share of it in the fund already, and then we buy another share alongside, but we still have a manager that controls it so that we don’t have to have that expertise ourselves.
Kuncheva: To my knowledge, large institutions have a history of hiring external consultants where they do not have the skills or the time to evaluate the individual loans, so they’re not buying wholesale loans and just blindly investing into them - they have some third party due diligence conducted on those. In time, as the institutions get more experienced, and the scale of investments allows it, they build internal research resources.
Where Finnish investors are concerned, Finnish pension institutions are obliged by law to extend credit to companies that have their employees’ insurance with them, so the Finnish pension insurers have the internal skills to price corporate credit risk, illiquid private debt, so that’s not really unusual. They’ve been extending credit to their own policyholders, investing quite actively in the broader Finnish private market as well, and now also the European market.
Finnish institutions have main-tained quite strong internal resources to invest directly in European assets, so I would say that in Europe internal investment organisations are quite comfortable within the major asset classes. Again, when it comes to more niche specialist strategies they are happy to invest with managers like us via funds, segre-gated accounts and taking advantage of attractive co-investment oppor-tunities in asset classes which require information and deal access, especially in real estate debt, infrastructure debt and distressed credit.
Chair: Are these co-investment examples likely to become more common?
Wendt: It looks like it’s becoming more common, but it is also at an early stage in my mind. I would think that you would seek external expertise when you enter new investments, but I think the big players will build up their own teams within the investment department in pension funds.
Chair: In hedge funds we’ve seen a number of examples of that, Varma is one example. Varma is working with a big fund of fund provider and then they will pick on their platform and they will help them. Similarly AP1 did a search for a platform provider with which to work on hedge funds. So it might be part of a new game that we are seeing - that investors like to maintain control but realise that they can’t really do everything by themselves?
Kunow: It’s certainly something that I’ve experienced. Investors need to have that insight and overview, they need to have control over the assets etc, and I think institutional investors are already pursuing it – like for example Varma in Finland, ATP in Denmark, PGGM in Holland and so forth.
Chair: I know that ATP is known for saying that strategy is 50 per cent, but implementation is the other 50 per cent?
Gosvig: In operating a pension fund, our approach has been that the main focus has to be on controlling the risk of the portfolio, and in order to do that we have to be able to get in and out of the investments and reduce and add on risk in the right places in the portfolio at the right time. So our focus has been a transition into a more controlled world so that our portfolio is more liquid or at least that we have tools that can control our risk. That does not mean that we are only going to be in liquid assets – it means that we need some proxies that can take out some of the risk of the illiquid assets pretty fast. So that’s the thinking we have applied to the portfolio.
Chair: What is the balance between the asset manager and the investment banks and the internal management when it comes to exposure to different asset classes? The way I see it, is that there’s a lot of discussion going on these days about the capture of risk premiums. How do you capture different risk premiums in the market? How do you capture low volatility? And so on. This can be captured in different ways. Are you seeing some sort of changes in this area?
Kuncheva: I think that the asset manager’s role is crystallising into what it should have been all along – about delivering alpha returns. With the pension investors there is a move away from benchmark thinking and benchmark allocations to a more absolute return driven investment strategy, and within that framework the ability to move tactically with the market. It is less about delivering beta but more about absolute return.
I think the big pension investors have woken up to the fact that a) they cannot be invested in one manager only, and b) if they diversify too much they only get the market return, so they are putting more thought into their allocations. Some have started using more passive strategies for mainstream asset classes, or maybe they have internal resources with strategic allocation in certain asset classes which are overlaid with, let’s say, derivative strategies, CDS or futures based strategies to allow frequent tactical allocation changes. Then there are those using external managers to deliver this part of this tactical alpha overlay.
Chair: But how should the managers do it? Should they have broader portfolios? Should they have more off benchmark port-folios? How would you shoot at this actual return?
Christoffersen: We have a couple of hedge funds in the fixed income area, and that’s one way to do it. If you target absolute return it doesn’t make much sense to put on a benchmark relative portfolio at current low yield levels. Moving into fixed income hedge funds, delivering quite a substantial alpha, is one way to do achieve absolute return in the fixed income area.
What we have also been doing, inspired by ATP, is delivering building blocks to inflation hedging so having a global inflation-linked bond portfolio, that’s been a successful strategy for us.
Chair: Per, how would you address the quest for more absolute type returns in the portfolios? Is it cash? Is it broad portfolios? Is it long/short?
Kunow: We continuously think about product development and as such we have seeded strategies in different styles over time. For example we have built portfolios with an absolute return focus (multi-asset set-up) as one option. I do think however there’s other ways; for example through managing concentrated portfolios with less risk than the benchmark. Yes, we are obviously talking about alpha generation through equities, but despite investors becoming more risk averse, we continue to see interest. We’ve also developed portfolio solutions where we combine fundamental and quantitative research thus achieving a better risk/return portfolio solution than a straight forward passive index strategy. Ultimately, I would say our prime concern and focus is down-side risk and quality. By consistently adhering to these attributes, we have been able to continue to deliver actively managed portfolios with a high information ratio.
Kuncheva: Our approach is slightly different – M&G has been investing Prudential’s money for years and we’re not trying to reinvent the wheel. We stick to taking informed risks while protecting the downside. We’re typically benchmark agnostic. We are not afraid to disagree with the market. Then we’re very disciplined in our approach - we find value in credit sector rotation, when our analysis shows the valuations are tight, we don’t overpay for risk, which results in attractive returns over the credit cycle.
Also, when we look at credits we look at a bit more than high yield and investment grade corporates – we look at ABS and also mortgage debt, be it senior or secure; we look for mispricing of risk between public and private markets, for the liquidity premium on the private side; for the balance between fixed and floating coupon sectors like managing high yield bonds alongside senior banks loans – having this large toolkit helps us manage credit over the cycle whilst protecting the downside with a very strong value discipline.
Chair: My impression is that Nordic investors generally have not been very much into multi-asset strategies?
Gosvig: Our credit portfolio has evolved since we started investing in credit at the beginning of this century, and we wanted to find some managers that could give us exposure at that point in time to high yield; later on we wanted to be more diversified so we went into emerging markets as well.
Our approach in the credit space has also been to try to do it as a barbell, basically buying into high yield and into investment grade and being able to switch between the two ends of the credit space by having a manager that actually gives us advice on where we should be at that point in time. Then when we added emerging markets it was also the manager’s role to advise us as to how we should switch around because we do not have enough knowledge internally, at least on how we should be able to do this, so we rely on our managers on how to run the portfolio.
Chair: Is it your impression that investors like to delegate the allocation, for instance, within fixed income to managers?
Wendt: I don’t think so. It hasn’t been the history. I think that investors all over the Nordics have primarily had these pockets where they could allocate money but to some extent it’s maybe a bit funny that you choose a manager to invest in investment grade and one to invest in high yields, and you take the allocation to these managers yourself instead of letting the favoured managers take that decision for you, because I guess you picked them because you thought they were the best to invest in that area. It should also be said that in Denmark many portfolio managers from investment departments in pension funds are very experienced and have built up strong capabilities in credit markets. Therefore, many of the pension funds are in a position to take care of the allocation internally. I guess they are in ongoing dialogue with their preferred external managers about this as well.
Gosvig: If I just may add that in the process of doing this we actually tried to evolve it in a way so that the manager could also go safe haven so it will be the manager’s choice actually to go into say just the US Treasuries, so that we also would allocate out of the risk. That created a big discussion with the managers because they did not have the framework to do this - they were working in the benchmark world where they could allocate between the benchmarks but they could not think out of credit space. So that was very difficult and it’s taken many years to drive that process.
Christoffersen: I would say I don’t necessarily agree with that approach. If you have very good credit managers, they don’t have to be the good market timers as well, so you are forcing something on a credit team where they don’t have the expertise.
Chair: What I would like to talk a little bit about is risk management and governance. Mads, maybe you could kick off by saying a little bit about how you see risk management at ATP?
Gosvig: ATP has had a lot of focus on risk management for the last 10 years. I think the Danish experience coming with the traffic lights from the FSA in the beginning of the 2000s and then the equity markets at the beginning of the century was a kick-start for both us and the rest of the sector to actually focus on risk management. We have evolved our risk management ever since and we are still evolving it and now we are integrating Solvency II into our framework. Our thinking has actually changed from believing that we can actually foresee the future and then invest accordingly - now we have moved into a framework whereby we are trying to avoid the biggest holes in the road in order to keep the portfolio as stable as possible while still being exposed to risk.
Chair: What trends are you seeing on risk management Michael?
Wendt: From a consultant’s perspective, I think the larger pension funds have developed their own risk management models, and of course everybody’s working very hard to try and implement Solvency II and other regulations. Both managers and pension funds spend a lot of money on investigating as an example how a mezzanine debt or direct lending strategy can be built into Solvency II, and maybe have less impact.
Internally at Mercer we use more than one model whenever we do a risk framework – we use traditional correlation models, we have developed factor models to understand risk premiums contribution to risk and return across all asset classes in the total portfolio, and we do stress testing, and so on.
Chair: What is the role of the asset manager when it comes to risk management? What can you do to help investors in this respect?
Kunow: It’s my experience that institutional investors definitely have, since the bottom of the market, increased their focus on what risk management structures do they and their managers have in place. Right from the individual security selection, to monitoring the aggregate portfolio risk, or even looking at it from a firm perspective. This is something that goes very, very strongly through organisations like ourselves - because we know we need to be on top of this aspect.
Kuncheva: Probably the biggest risk right now to the industry as a whole, both on the asset management and the institutional investment side, is the political and regulatory risk. It is rather constrictive and probably going to bring about unintended results in the longer run. From that point of view both investment managers and pension funds are facing higher or more detailed reporting requirements. On the investment side, talking about capital requirements regulation as well, we are obviously quite aware of the restrictions since we invest on behalf of our parent, the insurance company Prudential, so we cooperate with clients and help them to invest wisely and for the long-term.
Regarding the factor models and stress tests, yes I do agree that factor models are probably more useful right now. Stress testing and scenario analysis are part of our own internal portfolio risk management process. So altogether on the investment side, we make sure that our investors are rewarded for the risks they’re taking. On the operational side, counterparty risk has been quite a big issue for institutional investors recently. Our clients take comfort in the fact that M&G’s parent is a large, stable, publicly listed organisation with significant and long term commitment to the investment strategies we manage. This ensures proper alignment of interests and makes us a trusted adviser.
Chair: What do you think would be a dominant theme or change in the coming years in the pension industry? What do you think will set the agenda for pension funds in the Nordic region?
Wendt: There will probably be quite a bit of consolidation in the markets, I’m sure. You will have higher risk towards all the Solvency II issues; you will have to have a lot of internal things in place regarding the operational side and central clearing. It will be more costly for you to trade derivatives and OTC products all in all, so there’s really a lot of challenging things coming up. We have 55 people in a department at Mercer called Mercer Sentinel who focus on these issues. One of the growing interests from clients is operational risk assessments on managers which will be very important in the years to come - already very important in Australia and in other countries. Lately there has been high focus on managers of alternative investments. The boards in the pension fund will, due to the Solvency II rules, also take in more risks. How will they react towards the whole pension fund? Will they allow them to buy more tools, advice etc.? Will they be quicker to take that decision if it’s needed now when more risk maybe will be transferred to the board members? How will they react to the fact that investment management costs will be higher because you need to chase higher returns in alternative asset classes where there is a window of great opportunities for pension funds at the moment? That will be interesting to see.
Kuncheva: May I quote one Chief Investment Officer at a Finnish pension institution? The quote goes like this: ‘we do not pay pensions with relative returns’. Increased regulation in a low yield environment is an issue. How do you produce meaningful positive absolute real returns within this straitjacket is the challenge right now. However, the biggest challenge to the European pension industry overall is unfavourable demographics. We didn’t quite talk about that, but this is another challenging issue not only for pension investors, but for politicians as well.
Gosvig: I think I would like to mention two areas. One has been partly mentioned before and that’s the governance part. Solvency II will drive a huge focus on governance and it will drive more professionalism within the pension funds in the Nordic area. The other area is a bit more long term, but I think that pension funds will realise that they sit on a great asset, which is liquidity. Not market liquidity when you trade, but actual funding liquidity, and when central banks start taking away the punch bowl then it will be a very nice asset to have if you are able to deliver it to the market the right way. So I think that will be a theme but it’s not been perceived as anything interesting yet because it’s still central banks that are providing liquidity.
Christoffersen: I agree that yields will probably stay low for longer than we should wish for or hope for, and due to low growth, financial repression and demographics. We actually need assets to yield decently to give an income for savers and pensioners. If people are forced into risky assets and it’s not their preferred environment to take that much risk, I think that is the biggest problem. People are not moving into risky assets because they are convinced about it, they are forced into risky assets now because partly that’s all they can do to avoid a real loss absent outright deflation.
Kunow: A couple of factors have been mentioned, but I think the overall theme is the macro economic picture and the state of the financial markets, and that will continue to lead to more focus on regulation. I think another aspect is obviously consolidation and governance, then there are other factors like longevity that are being discussed too. Clearly, investors and managers continue to look for solutions to that. At the end of the day it’s very much a debate of finding investment solutions to the low yielding environment we currently are experiencing? And yes, I think even though maybe equities are not necessarily in favour, I believe there are good opportunities where investors have the risk budget.