Investing in hedge funds requires specific skills and careful monitoring. Pension schemes usually use hedge funds to ensure a robust diversification and the safest and perhaps easiest method of investing in this increasingly common alternative is through funds of funds. But for Ilmarinen, Finland’s €23bn multi-employer scheme, which has 3% or €750m of its overall portfolio in hedge funds, that is no longer enough.

llmarinen began investing in hedge funds in 2000.  As with most first-time users, it favoured the fund of funds approach, but from 2004 onwards, the emphasis has shifted towards a hedge fund strategy using single managers. This evolution means 60% of Ilmarinen’s hedge fund portfolio is now with single manager funds. Overall, the portfolio consists of 25 hedge fund managers and just a couple of fund of funds.

The scheme says it also employs two fund of fund counterparties to provide additional services in terms of single manager due diligence, thus allowing Ilmarinen to extend its internal resources. In addition, consultancy firm Albourne assists in both the due diligence process and ongoing monitoring of the managers.

Ilmarinen takes a unique view on hedge funds and how they should be used. “Hedge funds are not seen as a separate asset class within Ilmarinen, although they are managed as one. Instead, they are considered as a selection of strategies or activities,” it explains.

Ilmarinen says this means it thus views most hedge funds as managers of risk premiums. “Often hedge funds seek to capture risk factors with option-like characteristics, creating non-linear or asymmetric risk premium profiles, which can be attractive for investors.”

According to Ilmarinen, the returns from hedge funds come more or less from three sources:

alpha traditional beta alternative beta.

It has a clear view on where and how it can achieve alpha and traditional beta. “Alpha is scarce, and rarely sustainable and scalable in the long term, or is consistently achievable for just a handful of players. Traditional beta often appears in hedge fund portfolios as exposure to conventional asset class investment factors,” Ilmarinen says.
But alternative beta is a different animal and Ilmarinen splits this into three areas.

Firstly, it says hedge funds provide exposure to alternative factors or risk premiums that are not actually included in its strategic asset allocation as such. This represents a wealth of hedge fund strategies from the traditional more established convertible or merger arbitrage to the more recent exotic sources such as reinsurance, rare wine, art, films and even the weather.

“We have exposure to most of the traditional hedge fund betas directly. However, in the more exotic areas most exposure comes from investments in single managers with a multi-strategy investment process,” the scheme says.

Most but not all, Ilmarinen is keen to point out that it does use single strategy managers for some of the exotic allocations, such as reinsurance. “Another exotic exposure is an investment into a US sub-prime credit short seller, which will no doubt emerge as a good contributor in 2007,” it predicts.

The second alternative beta area consists of dynamic and tactical time-varying exposure to alternative or traditional betas. This includes investments in global macro and CTA managers. “If a hedge fund dynamically changes its exposure to a risk premium, but with time this reverts on average to a more neutral exposure, any excess returns created with this activity can also be considered as alpha, not only dynamic beta,” Ilmarinen says.

Third and final alternative beta area is structural beta, which seeks to take advantage of structural inefficiencies in markets related to regulation or the behaviour of certain investor groups. For example, Ilmarinen says it has invested in municipal bond arbitrage managers that take advantage of structural opportunities created by tax laws. Ilmarinen is keen to point out that it needs to take a flexible approach to the three alternative betas. “There is often overlap between these different sources of return, so the lines can be  somewhat blurred at times.”


Any pension scheme worth its weight looks for a little extra. “Alpha is of course something we strive for, but plain static traditional beta is not,” Ilmarinen says, adding it is therefore “not keen” on paying alpha fees for beta. “However, we are ready to pay alpha fees to get exposure to strategies and risk factors that are not in our strategic asset allocation, for which we have not set aside internal resources, or to which our access is limited.”

Ilmarinen is not content with the mix it has and such is its confidence in its hedge fund investments that it is seeking new areas it can include in the portfolio. “This will not only diversify the hedge fund portfolio but the overall portfolio as well,” the scheme says.

“We have investigated a number of potential new investment areas including life settlements, weather-related strategies, and environment-related strategies and risk premiums such as timber, water, and carbon emissions and trading.
Overall, Ilmarinen says it is very satisfied with its hedge fund investments. Returns reached 14.4% by the end of July this year and annualised return for the past five years has been about 10% with volatility under 4%. “Given this success, our hedge fund allocation is likely to increase to around 5% in the near future.”

Despite their growing popularity, investing in hedge funds continues to present challenges to pension schemes. Not for Ilmarinen, which through its forward-thinking and confident attitude, shrugs off the challenges and entering the largely unchartered waters of the single manager approach on a big scale.

True, its overall hedge fund allocation remains small at 3%, but this has not prevented the Finnish fund from developing a highly-diversified and efficient approach to its hedge fund strategy and the managers it invests in. Such is its zeal to succeed with its hedge fund investments, it is looking to invest in ever more exotic and unconventional strategies that will help it increase its hedge fund weighting to 5% in the very near future.