Continued diversification looks to new frontiers
With €15.9bn under management and rising returns, Finland’s Ilmarinen Mutual Pension Insurance Company (Ilmarinen) has been busy over the past two years, developing and fine-tuning its investment portfolio to meet the fund’s pension obligations for its members. Core to this aim is the continued diversification of the fund’s portfolio, which has been pursued across its asset mix. The fund’s investment team has also focused on in-house sourcing of alpha generation and skewness of the return distribution. In addition, socially responsible investment (SRI) guidelines have been incorporated into the investment decision-making process.
One area in which Ilmarinen has widened its investment net is in its bond and equity investments. At the beginning of last year, it introduced a major new theme into its equity investments by substantially increasing its equity allocation in Japan. Likewise, the fund has weighted itself more heavily in small cap companies. In 2003, the fund diversified its bond investments by including emerging market, high-yield and inflation-linked bonds into its bond benchmark. It has also branched out in its use of derivatives beyond tactical asset allocation. Where previously their use was limited to tactical asset allocation, it has begun to use derivatives in areas such as internal long or short portfolios in equities, as well as volatility trading in bonds and equities.
Introduced three years ago, Ilmarinen’s active currency overlay policy, has allowed it to increase risk exposure in other areas of the portfolio by reducing overall volatility, which has consequently allowed the fund to chase higher returns. Currently, the benchmark is 100% hedged for bonds and hedge funds and 50% hedged for equities. As a result of the investment team’s positive view on the euro from the starting point of €/$ 0.87 until the start of 2004, hedging was introduced then. The team reduced the hedge in US dollars and yen in 2004 when €/$ was at a level of 1.26. Since then, currencies have been traded actively using both forwards and options, which have gained from both the rate and volatility movements.
The fund has gradually increased its hedge fund allocation to 1.5% of total assets, comprising both fund of funds and single manager funds in a number of different strategies. Through independent research, Ilmarinen has carried out an in-depth study of the hedge fund universe and consequently developed a comprehensive selection process based on rigorous qualitative and quantitative criteria.
Whilst the return distribution of financial markets is not dictated by past performance, Ilmarinen’s assessment of risk is to a large extent determined by historic returns. As a result of a prolonged downturn, the fund was unable to restore its traditional basic allocation to equities in view of decreased absolute solvency and higher risk capital consumption within the fund’s solvency framework. In 2003, structured products were introduced into the portfolio to stabilise the expected return distribution and reflect the fund’s revised risk outlook. This new asset class consists of different types of call options on baskets of equity indices and zero coupon bonds. Ilmarinen says that the bond portfolio is managed actively and the options will feature, among others, lock-ins, knock-ins, Asian tails and varying equity exposures. By incorporating structured products into its asset liability model, the fund has been able to boost expected return without increased risk to the shortfall probability.
Another way that Ilmarinen has brought diversification into its portfolio is through its real estate investments. The investment team decided to widen the real estate portfolio in 2002 with implementation beginning in 2003. By investing in real estate funds, mainly in Europe, Ilmarinen has not just diversified the investment portfolio, but also increased the projected return. Although the advantages of property funds are higher yields, due to low liquidity they also take longer to invest in. During the transitional period therefore, real estate exchange traded funds, listed funds and structured products were used.
A new direction in Ilmarinen’s investment approach has been the adoption of SRI guidelines in 2003. The fund ensures transparency by employing an external consultant to screen the portfolio. The guidelines seek to exclude from the investment universe those companies that have breached international ethical guidelines, as produced by organisations such as the United Nations. To date, the fund has sold four holdings as a result of unethical behaviour. Yet, Ilmarinen also takes an active approach to SRI. At present, part of this active engagement translates into regular attendance in the AGMs of domestic corporations. However, moves are afoot to include the AGMs of companies abroad. Ilmarinen believes that by influencing the management at an early stage it can prevent undesirable motions being carried. Overall, it feels that the combined approach of ethical screening as a stockpicking device and that of active ownership, reduces risk and leads to enhanced portfolio returns.
Highlights and achievements
For Ilmarinen, a diversified approach to investment continues to be the way forward. Widening the investment spectrum is certainly reaping rewards, reflected in the fund’s overall recent performance. Although the team admits that the principal reasons for new ventures in bonds and equities have been correlation benefits and new potential sources of alpha, positive total returns have been in no small part thanks to the investment team’s market timing.
The inclusion of three new bond types into the bond benchmark, yielded between nine and 10 basis points additional expected return. Similarly, its currency overlay activity in 2004 has produced around 0.1% on aggregate portfolio level.
However, the fund has seen particular success with its basic hedging strategy. This has improved annual returns of the total portfolio by around 0.5% per annum over the past three years. Moreover, with the adoption of SRI guidelines, the move into the structured products market and diversification in its real estate portfolio Ilmarinen also continues to secure higher expected returns.