In an ever-changing investment environment, Nordic pension funds and insurers are becoming increasingly sophisticated. The professionalisation of the industry is noticeable across the region, despite local variations in asset class preferences, regulations and traditions.

While the trend of increasing equities versus bonds is continuing, other elements play a more important role. The focus has moved on to tactical and strategic allocation both in terms of types of asset classes and regions. A number of innovative solutions are researched in order to cope with the continuous challenge of how to increase returns and how to deal with a low interest rate environment for the foreseeable future. The changing investment environment is not isolated to the Nordic markets but is a market that is embracing new strategies faster than ever.

The low correlation between equities and fixed income in developed markets compared with emerging markets or alternatives, such as commodities or real estate, is attracting investors. Large funds are also separating alpha and beta in an increasingly complex and competitive world as well as moving away from market-weighted indices towards fundamental indexing. This means that the index is not weighted according to market expectations of company performance but instead captures reported fundamentals, such as P/E ratios and free cashflow. AP3 was the first fund in Europe to adopt the FTSE Global Wealth Europe Index last year.

An investment consultant in Norway says the changes in recent years have also led to a move from regional mandates to global and country mandates.

“Institutions which already invest in global products are looking to add returns by investing in specific countries. This is particularly noticeable in emerging markets, where fringe countries such as Vietnam are attracting interest,” he says.

Mats Langensjö, managing director of Aon Consulting in Stockholm, says that as the industry becomes more professional and knowledgeable investors become better equipped at portfolio construction. “The implementation of fundamental indexing is an example of this, where it is not the size of a company that is the deciding factor but the fundamental health of the company,” he says.

Taking time for real estate

Despite the apparent homogeneity of the region to outsiders, there are significant country variations where Denmark and Sweden are often viewed as the frontrunners in financial sophistication with Finland in a slightly different position, not least because of its adoption of the euro, and Norway playing catch-up to a certain extent because of its more prescriptive regulatory environment.

In Sweden, the largest market, private equity and hedge fund investments, are fairly widespread and expected to continue and increase. Some of the large insurers such as Länsförsäkringar have firm plans to more than double allocations to alternatives to 20 per cent. The increasing use of derivatives is also well-documented.

Other asset classes on the rise are infrastructure, commodities and real estate, in particular the move towards international real estate investments. AP3 specifically said in its annual report that it intends to invest in international property.

Chief executive Kerstin Hessius said: “Our longstanding aim to diversify the real estate portfolio into international markets will be realised in 2007.” She added that the fund’s analysis indicated that a diversification of the portfolio to include investments outside Sweden would be desirable. “We will work closely with our external partners to compile a well-balanced portfolio of international real estate funds,” she said.

International real estate investment among pension funds may be on the increase, but among insurers in Sweden it will take longer to establish. “There is the issue of finding property but mainly it is because of historic reasons. Some of the largest players, such as Alecta, suffered large losses in international property in the 1980s and the insurance industry still remembers this,” says Mr Langensjö.

Other institutions, among them some AP funds, are investigating forestry and infrastructure investments. Mr Langensjö says infrastructure investment is on the increase and is likely to become the next big asset class among Nordic investors as it fits with their quest for long-term investments and low correlation to traditional asset classes. “This will also help to offload the pressure on the region’s bond markets,” he says.

Reform in favour of equities

In Finland, larger players are also widening the definition of alternative investments from the usual private equity and hedge funds to include commodities and infrastructure. The arrival of the prudent person principle this year for Finnish pension investments has been widely welcomed. The change was a result of a reform to the €108.6bn Finnish pensions industry, which came into effect in January. Now, Finnish private pension institutions will be able to allocate a larger proportion of their assets to equities. The cap on equity investments was raised to 35 per cent from 25 per cent. The increase will be gradual over the coming five years, allowing an annual increase to equities of 2 per cent. The new regulations will also liberalise investments in alternative asset classes and in non-OECD countries. They are expected to increase the annual returns of pension institutions by approximately 1 per cent and alleviate the pressure on insurance fees.

In a recent nrpn survey, Ari Huotari, chief information officer of Finland’s largest fund, the Local Government Pension Institution (LGPI), said commodities and infrastructure investments are on the cards but the fund has yet to commit any assets. In the same survey, Timo Löyttyniemi, managing director of the Finnish State Pension Fund, which received a cash injection of almost €1bn from the Finnish government at the end of last year, told nrpn:

“We are aiming to have 10 per cent of our investments held in alternatives within the next two years, most of which will come from new money, but some of which will be redirected from our fixed income holdings.”

Pioneering alpha/beta separation

The Danes have been frontrunners in alternatives, private equity investments in particular. Players such as ATP, the country’s largest pension provider with assets of nearly DKr400bn (€54bn), have created sister companies for these types of investments. During 2006 it launched Private Equity Advisors and set up a representative office in New York on 1 January 2007. In addition, it set up another private equity arm, Via Venture Partners, which specialises in the Scandinavian IT sector. The private equity efforts are led by Jens Bisgaard-Franzen.

Diversification and the use of innovative solutions differ slightly in Denmark. Danish institutions have traditionally had a larger proportion of fixed income investment, compared to their peers. This portfolio composition in Denmark has lead to a diversification into high-yield and emerging markets fixed income investments, ahead of the other Nordic countries.

Peter Lindgren, director of business development for the Nordic region at US bond specialist PIMCO, says the other Nordic countries have often been very equity-focused and only had domestic fixed income.

“In the past, the high interest rate environment justified this strategy. Now many still get international exposure through swaps and other technical instruments on the fixed income side,” says Anders Bladh, managing director of Intervalor, a Stockholm-based third-party marketing company. He says Denmark has traditionally incorporated risk management in a different way. “It is not a risk-averse attitude, but rather a more complete view of the portfolio in terms of risk management, whereas in Sweden, institutions only considered currency risk, for instance, on the equity side,” he says.

In Denmark, ATP has separated alpha and beta. The changes were implemented during last year. The two are now embedded in a new structure, in separate portfolios and with their own CIOs. Henrik Jepsen is CIO for beta and Fredrik Martinsson CIO for alpha. A change in solvency regulations drove the Danish labour market fund to adopt its alpha-beta separation.

Because the bulk of the portfolio is given over to euro interest rate swaps, there is clearly a large pool of liquidity in the overall portfolio, and this is borrowed from the hedging portfolio at market rates. The bulk is invested internally and through external mandates in the beta portfolio. The alpha portfolio, in turn, borrows securities from the beta portfolio or short sells them and is therefore self-financing, with net assets close to zero, since it is close to market neutral in its operation. Now that the long-term liabilities are hedged with interest rate swaps, the role of the investment portfolios is to generate excess return to provide for the retention of the purchasing power of future pensions, since the hedging portfolio will only guarantee nominal commitments, and may not cover future developments.

Denmark has led the way in alpha-beta separation, but some of Sweden’s AP funds are also implementing the strategy.

Norway’s high benchmark

In Norway, the regulatory framework is more restrictive and the 5 per cent limit on alternative assets has resulted in fewer exotic elements in the institutional portfolios. According to a spokesperson at the Norwegian regulator there is a proposal to increase this limit to 10 per cent.

The Government Pension Fund – Global, formerly the Petroleum fund, is setting a high benchmark for the country, according to Mr Langensjö. The fund is viewed among its Nordic peers as a pioneer in many fields but is not viewed as particularly representative of the country, mainly because its size and specific investment guidelines have necessitated an international outlook and diversification. It is expected that investment guidelines, set by the Ministry of Finance, will include real estate investments for the fund.

Regulatory liberalisation in the past paved the way for more international exposure and diversification in most countries and continues to do so, as illustrated by the Finnish reform and the proposed changes in Norway. As international exposure increased, so has debate in local media about the rights and wrongs of taking pension money abroad. However, this debate seems to have moved on and few investors feel any real pressure to invest in the domestic markets, simply for the sake of it.

Mr Bladh believes that it is rare to hear these arguments, apart from possibly among the labour unions. “There are valid reasons for Nordic institutions to invest domestically as markets have done well,” he says.

In a previous nrpn roundtable, few funds expressed any pressure to invest domestically in order to support local businesses. “We do not feel any particular pressure to invest in Sweden,” said Länsförsäkringar managing director Hans Sterte. “We try to invest wherever we find the best investment opportunities. At the moment our domestic equity exposure is approximately 12 per cent of the total portfolio. We have no plans to change this in the long term.”

Mr Huotari also noted at the time that LGPI had featured in the debate because of its global diversification. Other institutions such as PFA in Denmark and Vital in Norway concurred.

Mr Langensjö says the diversification benefit does not improve hugely whether you have zero or 20 per cent in domestic equities. “To have the exposure at the higher end of the scale may give you an information and transaction cost advantage,” he says.

He also notes that headlines often lead to knee-jerk reactions among politicians, and therefore funds such as the AP funds make the news when it comes to foreign investments, their position in merger and acquisition situations or corporate activity.

Flexibility is key

Increased corporate activity has also pushed institutional investors into the corporate governance arena and in recent years towards ethical and environmental investments. Nordic institutions continue to develop in the area of socially responsible investments and are demanding the adaptation of certain ethical or social criteria to an ever-wider range of assets classes. The most recent example is the launch of an ethical emerging markets fund managed by BankInvest, a Danish fund manager with €2.5bn in emerging market assets. The fund has amassed some €50m of seed money from backers which include the Norwegian and Finnish church as well as a Swedish labour union.

The ever changing and challenging environment requires the pension funds of today to adopt flexible investment strategies to cope with the liabilities of tomorrow. The Nordic region has a history of innovation and entrepreneurial spirit which has always embraced change. This attitude was not the norm just 10 years ago when retirement issues were concerned. The agenda has changed and now the Nordic countries are well on their way to catch up with their Anglo-Saxon teachers, and maybe even surpass them if they continue to adopt new strategies at the current pace.

To do so it is vital that regulation also keeps up. In AP3’s annual report, Mrs Hessius says: “The regulations for the AP funds introduced by parliament in 2000 were, at the time, among the most modern and flexible for state-owned pension funds anywhere in the world. The only thing they did not cater for was the rapid pace of change on financial markets. With hindsight, the regulations should have included mandatory reviews of the investment rules.

“It is now six years since the pension reform and it is high time the rules were reassessed. If not, there is a major risk that the AP funds will lose ground in the competition for new investment opportunities. The current investment rules for private equity limit our scope for investment in infrastructure assets, which are gaining popularity among pension funds. Our hope is that the rules will be reviewed in 2007, in an orderly process and without other alterations to the pension system.”

Nordic investors see more equity exposure as the way forward

According to the results of nrpn’s latest quarterly investment survey, which polled 16 major Nordic investors with more than €230bn of assets under management, 40 per cent of respondents intend

to increase their exposure to equities over the next six months – despite two-thirds of investors having concerns over market risk.

The study also found that almost two-thirds of Nordic investors plan to dump a proportion of their bond holdings going forward, with just three respondents planning to increase their exposure to the asset class. Nearly half of investors, meanwhile, intend to raise their property allocations.

Jon Lekander, head of investment strategy at Aberdeen Property Investors in Stockholm, says: “The Nordic region remains an interesting market for investors looking for strong growth and regional diversity. All five countries are performing well, but Norway stands out as the best single market.”

Out of the 16 polled investors, 60 per cent of respondents believe world growth prospects will remain positive over the next six months and 40 per cent expect prospects to remain neutral. Not one believes prospects will be negative. See pages 16 and 17 for full survey results.

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AP funds continue to adapt and prosper

Sweden’s so-called AP funds were established as buffer funds within the country’s reformed retirement system in 2001. They are often seen as a benchmark for the Nordic pensions industry and represent the region’s ability to adapt to a changing world.

Since the start, the first, second, third and fourth funds have gone through many changes regarding their investment approach. The four are competing funds and today their separate identity is more apparent than ever. Despite this there are also areas where they use their scale to co-operate. The four funds created a joint Ethical Council and appointed GES Investment Services as an adviser in February (see page 10).

In 2006 many of the funds implemented new innovative ways to deal with an increasingly complex and challenging investment environment, and 2007 promises to follow the same path of change.

Last year AP1 hired six new external managers for emerging markets. The fund now uses external managers for 34 per cent of total assets, and 76 per cent of assets are actively managed. Chief executive William af Sandeberg commented in AP1’s annual report that the percentage outsourced would not change but the existing mandates would be put out to tender to test market competition. The fund is currently tendering a Japanese equity mandate of US$1.2bn (€0.9bn), expected to be funded by 1 July. In addition, the fund is also conducting an ALM study which may mean further changes.

During 2006 AP2 increased its quant-portfolio to 31 per cent from 11 per cent and manages 79 per cent of assets in-house. The fund’s investment professionals believe that you will get a better result with a few mandates with extremely low correlation. Poul Winslöw, head of asset management since 1 January this year, said in the fund’s annual report that the fund is going to adopt a new structure with the separation of alpha and beta.

AP3 reviewed its portfolio structure and began researching the separation of alpha and beta. As well as continuing to develop its strategic and tactical asset allocation capabilities, the fund adopted fundamental indexing, moving away from market weighted indices. It also continued to increase its use of derivatives. The fund wants to implement alpha and beta separation during 2007. It also aims to invest in international real estate for the first time, as well as continuing to use derivatives as a strategic tool. The fund is currently tendering for between three and seven global tactical asset allocation mandates to complement its internal team.

The fourth fund conducted an ALM study in 2006 which suggested that it should increase its equity exposure as well as investing in real-estate, high-yield bonds and hedge funds. However, AP4 found it needs more analysis before venturing into any new areas. In addition, the fund has appointed as chief executive Mats Andersson, formerly CIO of Skandia Liv, following the retirement of Thomas Halvorsen.

The four funds continue to deliver investment returns, but also adapt and research new ways of keeping ahead of the game.

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