The perennial search for diversified sources of return is leading Nordic pension funds into areas less trodden. Unprecedented growth in interest in alternative investments such as hedge funds, private equity and real estate has spurred funds to expand their horizons and seek out less crowded corners of the market.

Danish funds are challenging the old adage ‘money doesn’t grow on trees’ by diving head first into timber, while exotic assets like water and clean energy are moving quickly on to the radar screen of the more shrewd and forward-thinking investors.

Why buy trees? The key attraction, according to a report published by Watson Wyatt last year, is a ‘real’ asset that has returns uncorrelated with equities and bonds. There is also a chance for active management to produce superior returns, and timber may offer some protection during equity bear markets.

In fact, pension funds in Denmark have been investing in Danish forests for some time now, says Søren Andersen, CEO of Danish consultant Invensure.

“Not every pension fund has been investing in forestry but quite a few have,” he says. “My guess is that we will see an increase in non-domestic investments. This is true for every asset class, even fixed income which has been very much linked to Danish government and mortgage bonds.”

The €3.8bn AP Pension entered the fray in February this year and now allocates 2 per cent of its assets, or €80m, to timber through five funds invested mainly in the US.

PKA is another follower, with a 1.5 per cent allocation spread across the US, South America, Australia and New Zealand.

Sweden warming to timber

Timber investment is less prevalent in Sweden, but is certainly gaining momentum.

The €22.6bn buffer fund AP 3 has committed SKr1bn (€106.5m) or 0.5 per cent of its portfolio to forestry, of which SKr900m was invested by the end of last year, mostly in international timberland funds.

Other proponents are Swedish pension insurance company Länsförsäkringar and the €3.5bn Kåpan Pensioner, the pension fund for Swedish government employees.

Kåpan invests 3 per cent of its portfolio in timber via non-listed Swedish company Bergvik Skog, in which it is the fifth biggest investor, and two externally managed timber funds.

Bergvik Skog AB was formed in 2004 when Bergvik acquired all of Stora Enso’s and Korsnäs’ former forest holdings in Sweden, including 1.9 million hectares of productive forest land.

“The investment in Bergvik was our first investment three years ago and since then we’ve invested in two external timber funds which are global and very diversified,” says Gunnar Balsvik, president, Kåpan Pensioner.

“It’s a way for us to diversify the big holding we have in this Sweden-based company, so we have a more diversified timber portfolio than just Swedish forest.”

Kåpan is also one of the pension fund backers of Guernsey-based Phaunos Timber Fund, the first listed timber fund in Europe.

The fund raised $115m (€85.8m) when it listed on the Alternative Investment Market (AIM) in December and is managed by Geneva-based Four Winds Capital Management.

Externally managed funds are just one of several ways to invest in timberland.

According to Watson Wyatt, the approach taken varies depending on the size of the institution – large funds can choose segregated accounts or limited partnerships known as Timberland Investment Management Organisations (TIMOs), while smaller investors can opt for timberland Real Estate Investment Trusts (Reits), although the liquidity of Reits arguably destroys the premium for investing in an illiquid asset.

Cash flows come from two return streams – income derived from sales to lumber and paper companies – and capital gains from tree growth and land value.

Chris Armitage, head of UK at Four Winds, says: “Modern timberland is a new asset class effectively. The Nordic region recognises forestry and always has done, but we are now doing things differently; it’s not just a matter of buying a forest and sitting on it, the new opportunities are about doing things with timberland that add value.”

Phaunos seeks exposure to timberland on a global basis with portfolio diversification through tree species, age classes and geographical timberland markets.

Four Winds also uses timber related instruments like financial futures, options, warrants and swaps, the return on which is linked to timber related indices or other instruments or vehicles.

Unlimited potential

But the quest for returns and portfolio diversification does not stop at timber. As Nordic funds become more comfortable with alternatives, they are expanding the range of assets they are willing to consider, the only stipulation being the potential to add value within the fund’s given risk parameters.

“These types of investment products, including environmental infrastructure, are right in the corner of most unusual but the big funds want things that are not correlated and these most unusual products tend to work,” comments Mr Armitage.

One recent example is PKA’s decision to allocate more than €120m to an unlisted Danish company which recycles old car tyres.

The investment in Genan represents PKA’s first direct private equity investment, and according to chief investment officer Michael Nellemann Pedersen it is in line with the fund’s desire to boost investments in the growing environmental industrial sector.

Genan has invented a technique to refine rubber, steel and textile from used car tyres, which can then be used in new products, such as asphalt. The company is planning to expand into the US and Europe and set up 10 new factories in the next eight years.

“We always focus on the risk/return profile first but we have a decision by our board whereby if possible, and if the risk/return profile is to our satisfaction, we will try to find investments with a positive environmental angle to them,” says Claus Jorgensen, head of equities at PKA.

“Our allocation to private equity has a target of 5 per cent which we expect to reach within four to five years but that’s mainly through funds and fund of funds, so in that respect, our investment in Genan is outside our normal strategy and was considered a special opportunity.”

However, Mr Andersen at Invensure says given the established history of private equity investment in Denmark, it is not surprising that funds are investing in niche areas.

“If you look at those investments directly owned by Danish pension funds you’ll probably find lots of peculiar investments but it is not to do with the idea of a certain area being a new asset class, it’s more to do with investing in private equity,” he explains.

There may also be an element of pressure on the part of the pension fund members to find ethical or socially responsible investments, adds Jan Willers, financial analyst at Kirstein Finans.

“We have seen these socially responsible investments, particularly in some of the labour pension funds that involve public sector employees who are pushing it, whereas the big commercial pension funds don’t have the same interest at this stage,” he says.

Looking for a clean alternative

As the world’s dependence on oil fast approaches crisis point, the concept of ‘clean’ or environmentally responsible energy consumption has also come to the fore.

Clean energy meets the dual needs of growing demand for electricity and natural gas from consumers while reducing emissions of air pollutants and greenhouse gases.

The International Energy Agency in Paris has projected global primary energy demand will increase by 53 per cent between 2004 and 2030 to over 17 trillion tonnes of oil equivalent – an average annual rate of 1.6 per cent.

With fossil fuels such as coal, oil and gas remaining the dominant source of energy, fund managers have begun launching products which aim to profit from investing in more sustainable forms of energy.

In May, Pictet launched the PF (LUX) Clean Energy fund, which invests in companies that contribute to and profit from a transition to more environmentally friendly energy consumption.

These companies operate primarily in the development of technology and equipment, as well as infrastructure and resources, including renewable energies.

On a global scale, renewable power has seen an influx of cash from investors over the past 18 months, with more than £35bn injected into wind and solar power and biofuels in 2006, according to the United Nations.

Yet in the Nordics it appears that at this point momentum is being driven by the providers rather than the investors.

Nicklas Fahlström, senior consultant at Wassum Investment Consulting in Sweden, says: “There are hedge funds that operate on the energy market but they’re not long-only, so they are more trading oriented. I haven’t seen any big demand for clean energy funds.”

One area that has caught the eye of a handful of Nordic funds is water, which is being increasingly viewed by fund managers as a tradeable commodity.

Jorgensen at PKA says: “We haven’t invested in water funds but potentially that could be something for us as well.”

However, Mr Balsvik at Kåpan Pensioner is unsure whether water provides the low correlation with equities that the fund is seeking.

“We have looked into water funds but we can’t really fit it in anywhere other than in the equity portfolio. We don’t see water as a commodity; it’s more a sector within the equity market.”

The Triton Water fund, managed by Four Winds, is a global water fund of funds that focuses on water-related businesses worldwide.

Mr Armitage admits that the fund has an equity bias, but insists it is not an equity fund.

“Our fund is effectively a hedge fund, so it does invest in equities but it has a shorting of the beta, so it takes some of the equity market risk away,” he says.

“We are looking to get value in the long-term from the fact that water is an increasingly constrained natural resource. Nordic countries have plenty of water but there are lots of places like the Middle East that haven’t, so investors look at it as an opportunity to find things that other parts of the world will want to invest in.”

Ensuring adequate protection for volatile times

When mulling over the chaos that has swept across global equity and bond markets in recent weeks, Mark Duke, principal at Towers Perrin stressed one key message for pension funds: you are kidding yourself if you think you can ever get extra return without risk.

The decline in stock markets coupled with a fall in bond yields, both triggered by the sub-prime mortgage crisis in the US, has served as a reminder to pension funds across the globe that even the ‘safest’ of investments are not without risks.

But when it comes to alternative investments, that risk is amplified, making rigorous risk management processes even more crucial.

With pension funds in the Nordics constantly expanding their investment horizons, Claus Jorgensen, head of equities at PKA, admits the risks become harder to monitor.

“In some cases, the history you have for evaluating the assets is much shorter than for traditional equities and bonds so in that respect it is more difficult,” he says.

“But both for timber and infrastructure we believe we have sufficient data to be able to analyse the assets and see what potential they have and what their risk characteristics are.”

One of the primary risks associated with niche investments like timber is their illiquidity relative to readily tradable traditional assets like equities and bonds.

Ironically though, it is this very characteristic that makes timber attractive to many Nordic funds.

“We’re trying to find illiquid assets that are less volatile than equities on a monthly basis,” explains Gunnar Balsvik, president at Kåpan Pensioner in Sweden.

“It’s part of the new regulatory framework, which makes you a little bit sensitive to volatile assets so we’re looking for diversification and illiquid assets, or assets that are not publicly listed like equities are.”

The hunt for these diversified sources of return undoubtedly places greater demand on the governance budget of the pension fund.

With stringent due diligence required before delving into the niche end of the market, such investments have thus far been limited to pension funds giants with strong in-house capabilities.

Jan Willers, financial analyst at Kirstein Finans, says: “It can be hard to find investments in some alternatives with a long enough track record – not only performance – and therefore it can be hard to measure the actual risk in the funds. It can require more of the pension fund to manage the risk when investing outside the mainstream and this could call for the use of a consultant to monitor the investments.”

AP Pension strays even further from the herd

The €3.8bn AP Pension is so confident about the benefits of investing in niche assets that the fund’s deputy chief executive officer, Søren Dal Thomsen, believes alternatives could have a larger stake on pension fund balance sheets than equities in 10 years’ time.

The Danish fund, which counts timber, African private equity and ‘venture-type’ commodities among its quirky assets, is seemingly one of the Nordic region’s most forward-looking pension funds.

“We have always thought that the most important thing is to exploit any opportunities to produce the highest possible return for our clients but you are also a product of the environment you work in,” says Mr Dal Thomsen.

“Ten years ago only bonds, equities and property were on the radar screen. You wouldn’t dream of considering investing in forests or private equity in Africa, but today the investment possibilities are much wider and it’s more natural for you to pursue anywhere you find interesting so I think we’ll see the horizon of asset classes or investment possibilities continue to expand.”

Although private equity investment is commonplace in Denmark, AP Pension is fairly unique in its exploration of new frontiers.

“Africa is the only place in the world where there isn’t excess liquidity,” says Mr Dal Thomsen.

“Everybody is willing to take risk in the normal emerging markets like Asia, Latin America and Eastern Europe but nobody talks about Africa so therefore the competition for deals is not so tough. Also as a private equity company in Africa you can add more value simply because the corporate governance you can add to the company to nourish the financials is not present in Africa to the same degree that it is in other emerging countries.”

It has also strayed from the herd in choosing the active route to commodities, rather than passive investment through indices.

Although AP Pension has not yet invested in clean energy or water funds, it appears to be a case of ‘watch this space’, with Dal Thomsen hinting that an investment of this nature could be just months away.

“We think this is an area you should look at,” he says. “We believe that wind is probably the best place to start, but you shouldn’t neglect the possibility of solar or water.”

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