Following the collapse of Iceland’s three main commercial banks in 2008, and the subsequent introduction of capital controls by the Central Bank, Gylfi Jónasson of Festa Pension Fund was left with a portfolio over two-thirds invested in the nation’s government and municipal debt.

It was not an exposure he particularly desired for the ISK89.4bn (€556m) fund, but one that reflected a situation whereby local corporate bonds and equities were “wiped out”, leaving him with few places to invest member contributions.

While its domestic fixed-income exposure has since fallen to around 40%, Festa did benefit from the significant index-linked holdings. Jónasson says the exposure – over holdings of nominal debt – was “simply the smart thing to do” given both the shape of the fund’s liabilities and a post-crash economy that saw domestic inflation at 12.8% in 2008 and 16.3% the year after, according to Eurostat.

Despite this, the insular nature of Icelandic pension investments – a result of the currency controls – is still of concern. The Central Bank has indicated that the controls will only be lifted gradually.

“This is the biggest challenge, because Iceland is not a big market, it is not a big economy,” says Jónasson. “Our country risk is increasing by the day, so of course we follow whatever policy developments there are regarding monetary issues.”

However, he notes the challenge posed by currency controls is not an insurmountable one. “You become creative when you’re restrained like that.”

Due to the low level of overseas holdings, Jónasson says the fund feels liberated to take greater risks with what remains. It therefore has no overseas fixed income, instead focusing on listed and private equity. Until early 2013, Festa also had an allocation to hedge funds, but it was decided that these were no longer required.

It has benefited from its commitments to overseas private equity predating the crisis. Instead of netting capital returns, the fund returns any investment gains for re-investment elsewhere, as well as drawing down any further capital required, allowing the fund to still boast a 16% overseas exposure, down from around 30% pre-crisis.

Discussing his meetings with the private equity managers, Jónasson says: “They were quite surprised, of course, but when we explained, it was a dead giveaway.”

As foreign currency exposure has declined, the need for hedge fund exposure to balance out volatility has also fallen away, according to Jónasson, who explains that apart from US dollar and euro denominated holdings, the fund now has only minimal exposure to the Japanese yen, Swedish krona and Danish krone.

“The divestment was a strategic decision because the idea was that hedge funds were supposed to have a different correlation to other asset classes. They used to – they don’t anymore.”

Instead, Festa has built up a small Nordic equity portfolio, and Jónasson has been pleased with the recent double-digit returns seen by stock markets in the neighbouring countries. Additionally, around 40 MSCI-indexed and actively managed equity funds account for the remainder of the equity holdings.

According to Jónasson, the fund can also look forward to “fairly positive cash flow for years to come”, allowing it to continue its pursuit of domestic private equity.

Admitting that it was a “painful” decision – due to the risks associated following the crash – to invest in domestic private equity, he says that several investments have already paid off, and an understanding of the local market helps considerably.

“We have been much more active in co-investing, that’s really been quite fruitful. We have seen a few listings come out of that, returns have been quite interesting,” he admits.

Jónasson says the ability to tap into the market has been helped by an investment manager – launched alongside and jointly owned with two local pension funds – which has allowed Festa to sidestep the need for in-house expertise in the area.

Domestic commercial real estate has also been an area of growth – through fund investments, Jónasson stresses, as Icelandic pension funds are unable to directly own properties themselves. He says the regulatory restriction is a “very strange phenomenon”.

“Every country has its peculiarities and whereas with our colleagues on the continent and even in the [United] States you can see physical real estate features in their portfolio, that cannot happen here. We can invest in real estate funds, though, and have made several such investments in recent years.”

Three commercial property funds, in which he says Festa was a “quite early entrant”, have made returns that Jónasson appreciates, offering a combination of equity risk and bond certainty.

While residential real estate has yet to attract any investment, he notes that the fund offers its members mortgages, giving them secure exposure to the gradually recovering housing market.

However, domestic equity has not been absent from Festa’s portfolio, despite the potential for an asset bubble developing as the €15bn pension industry allocates to listed stocks. “We tried to emphasise equity that has a foreign flavour – even if it is a local company that has perhaps 80% or 90% of its income in foreign currency,” says Jónasson. “We are trying to de-risk in every area that we can.”

Infrastructure is also potentially attractive, although Jónasson stresses that the asset class poses unique problems and can be “very, very risky”.

“There’s political pressure around it. There is pressure on pension funds showing themselves to be good citizens,” he explains. “Some of these projects that are politically driven may not be economically viable, that’s the problem with infrastructure projects that are driven and originate in the political sphere.”

Alongside the equity asset classes, there has also been growth in the corporate bond market, which he says is “opening up a bit”. Of the growth in the asset class, he adds that it is where pension funds “can compete with the banks”.

Both equity and bond investments in the national power company, Landsvirkjun, have been attractive and Jónasson regards the firm as “perhaps even more secure” than government bonds. “Even if the state would fail, that’s a pretty viable entity,” he adds. “We’ve always looked at that and been very keen and buy bonds from power companies.”

Investments in energy distribution networks used by local power company HS Orka – active on the west of the island, which is traditionally Festa’s catchment area  – have also been a way of diversifying. The investment, made through a private equity fund, saw several local schemes join to acquire a 33.4% stake. However, it is actually the Landsvirkjun bond holdings that have benefited Festa and other Icelandic funds, as the ISK-denominated paper pays its coupon in re-investible US dollars.

There are also other ways of increasing foreign currency holdings, without having to rely on coupons or cash calls from funds.

“Some of the failed Iceandic corporates now in liquidation – we have bought assets from these estates,” explains Jónasson, noting that one company with a Dutch affiliate gave them access to its non-ISK denominated holdings. The acquisition was again a team effort, with six schemes in total seeding the private equity vehicle behind the acquisition. “So, we managed to increase our foreign currency assets, to a small degree, through these types of exercises.”

For the future, Jónasson says that one of the largest risks is an asset bubble developing, something he views as “highly likely”. “It is something we are very concerned about. So far, the listed equity is still reasonably priced, but a bubble could still happen.

“There is a flip-side to the lifting of the currency controls, the re-alignment of prices,” he adds. “This is just a part of the huge country risk we are facing, which is why we are trying to spread our investments as far and wide as we can.”