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Danes ready for next challenges

While pension funds and asset managers in many other parts of Europe are assessing the implications of new regulatory structures, be it the introduction of the traffic light system in Sweden or the new financial assessment framework (FTK) in the Netherlands, their Danish counterparts can be forgiven for viewing their manoeuvrings with a certain complacency.

“Denmark is completely different because we made all these changes back at the end of the last century,” says Ketil Petersen, managing director at Schroders IM. “The regulator came up with the traffic light proposals back in 1999, and the system was implemented in 2001.”

“The Danish financial authorities had had their eyes on the sector before the downturn,” says Stig Mølsted-Møller, senior vice-president ABN Amro AM. “There had been a banking crisis and then problems with mortgage institutions back in the mid-1980s and early 1990s.”

“The authorities implemented the traffic light system because at that time the pension fund industry could only invest up to 40% of a portfolio in equities but they were pressing for the ceiling to be lifted to 60%,” says Petersen. “The regulator conceded the point but said that in such a case it would require more on the risk side, and that meant it had to come up with some form of risk-control system. So the traffic light system was developed to ensure that pension funds could not just go out and invest 60% in equities if they didn’t have the risk budget to do it. It was a clever move and it came in before all the market turmoil. I would say that the traffic light system has served us well because no pension fund today is underfunded so we don’t have the same issues that they have in other European countries.”

“It forced the pension funds to employ derivative structures to immunise their liabilities,” says Jesper Kirstein of consultancy Kirstein Finansrådgivning. “And this in turn has had a profound effect on the way they carry out their asset management.”

But it also illustrated the dangers that such moves can have for asset managers. When traffic lights came in and pension funds needed to mark to market, the asset management sector did not have suitable products and lost the business to investment banks.

“The introduction of the traffic lights and the move to mark to market coincided with a fall in global interest rates and problems in the equity market,” recalls Petersen. “This forced the pension funds to focus more on the risk side and their risk budget than before when, in my view, they had paid more attention to the return factor. This in turn gave rise to a major change in the way that pension funds needed to cover liabilities. There was a demand but we couldn’t offer the solutions at that time, and so the investment banks came in with their structured products. It has changed now, because we have different solutions. There’s much more focus on risk control and much more talk about LDI and again Denmark has been in the forefront because many pension funds do cover liabilities by investing in derivatives, immunising the risk on the liability side. By doing that they can free up some reserves that they can pay out to their members’ accounts or it allows them to invest in more asset types than they have before, so diversify. And that is a trend we see today.”

But the introduction of the traffic light system was known about for several months before it happened so did the loss of the liability-matching business to investment banks not represent something of a defeat for the asset managers? “It changed the market place,” says Mølsted-Møller. “They had always been there, servicing the pension funds that were managing part of their portfolio themselves with only a limited outsourcing to asset managers. Interest rate swaps and products to hedge liabilities were already a big part of the brokerage business, so they could just take that to a new client sector, the pension funds that had not used them at all in the past. But I don’t think that was taking any major business from the asset management industry because while the brokerages took a big chunk of the liabilities hedging business we also maintained a good relationship with the pension funds through our advice and inputs on strategic portfolio and tactical asset allocation. So, even though this business was outside the asset management industry, the market has since grown substantially. Increased diversification and the entrance into much more specific alpha products and niche markets have provided a lot more business for the asset managers. So if you compare how much pension funds did themselves and outsourced 10 years ago and today you will see that a lot more is done with external managers now.”

But do investment banks still pose a threat? “They certainly provided liquidity and size on interest rate swaps at the time when the traffic light system was introduced, which helped people with what were immense problems, and that was a solution that traditional asset managers couldn’t deliver,” notes Daniel Broby, member of the investment board at BankInvest AM. “But those problems have gone now and in this business things do move on. The latest solutions they are touting around town are pretty much quasi asset classes - and I say quasi because you have to make the case for the asset class before you make the case for the product - such as infrastructure funds and commodity funds. These products certainly have interesting return characteristics and are probably good diversifiers in a pension fund portfolio but it’s not proven that those returns are repeatable. And that’s something that you get from an asset manager; we have a process that we can define and therefore show we can deliver in the future. With commodities, for example, with the investment banks we are talking about playing the backwardisation of the commodity yield curve, which we know is not a phenomenon that is persistent in time. Also you have to worry about what commodity index you are balancing yourself against, and the trouble with commodity indices is that they are pretty much production based and production-based indices are very heavily tilted towards energy. Pension funds are savvy enough to know these issues, and if they are not we will tell them.”

“Investment banks went in big time, then they disappeared and now they are starting to come back again,” says Klaus Hector Kjær, partner and director at Gudme Raaschou AM. “They made some personal relationships in 2001 but I’d say we are not really competing for the same money.”

“Investment banks are all over the place, and they are definitely competing,” says Peter Preisler, head of business development (EMEA) at T Rowe Price. “Many people are using them if they have something unique to present to the market, they may have structured products for some mid-to-smaller institutions. But the larger institutions are building up the expertise in-house that investment banks are trying to sell in a packaged form. There will be transactions but the real money generator - the structured products - will not be as successful here as elsewhere. People know what it costs and they know they can structure their own things.”

“Having covered liabilities with derivatives means that you don’t necessarily want to invest in traditional fixed income,” notes Kirstein. “You are free so do other things.”

“The strongest trend at the moment is a shift from relative to absolute performance,” says Kjær. “We’ve been talking about it for two or three years but now things are really happening, and it’s happening across the board - in the first-tier pension funds, the mid-sized and the third-tier players. In practice it’s being implemented via a change of investment strategies, the most important being that new mandates are now made without benchmarks while benchmarks are removed from the investment guidelines of existing mandates. And this is really altering our focus. Benchmarking had been a good thing for asset managers because if you’re close to your benchmark investment-wise you’ll never get kicked out. But investors haven’t been too happy with the returns coming out of the portfolios and looking at reporting from managers they discovered that often managers were more focused on benchmarks and relative performance. So there has been a gap between where the investors want to go performance-wise and where the asset managers are taking them. The investors are becoming more professional.”

“The demands are changing with market circumstances and with developing opportunities to use the market in a much broader way,” says Mølsted-Møller. “So we have
been working on diversifying the concentrated portfolios of equities and fixed income, looking into the underlying elements and building more-balanced portfolios that can respond more flexibly when developments change or become more threatening. We see the asset management industry introducing new factors, starting five years ago with high-yield bonds and emerging market bonds that were not in pension fund portfolios at all but which have some very nice diversification effects and have a major role in portfolios today.”

“There’s a hunt for more diversification and for alternatives,” says Petersen. “Having covered a lot of their liabilities with derivatives pension funds don’t need to have 50-60% of their portfolio in pure fixed income. So some of that money, maybe 5% or more, will be put into other areas, like hedge funds, more private equity or international real estate, to get a better total risk-adjusted portfolio. There’s still a resistance to hedge funds but a handful of pension funds have invested in them already and there is a growing acceptance that they can give some attractive return risk patterns.”

“There is limited appetite for hedge funds,” agrees Kjær. “Pension funds are realising that hedge funds are not an asset class but that we have numerous asset classes within hedge funds. People were saying that they were an asset class that gives a lot of diversification and negative correlation and so on, but while that happened at the beginning it’s not happening now. And people are starting to realise that hedge funds are going in various directions. In addition, the cost structure does not fit into the way that Danish pension funds are thinking, especially funds of funds. In Denmark people are not willing to pay the 2/20.”

“Hedge funds are too broad a concept,” says Preisler. “It may have to do with timing: it’s very difficult to convince anyone that hedge funds are the holy grail after a year like this. People tend to have the opinion that hedge funds are good to have in the portfolio, but access is expensive and they are non-transparent. So they’re balancing on a knife edge where people feel they should have them but it is difficult to make the argument why it should be right now and by the way it’s damned expensive and there may be a risk they’re picking the wrong one if they don’t pay what it takes to get access to the best. So it’s there, it’s growing but it’s difficult.”

“Some years ago several pension funds began investing in private equity by investing directly in non-listed companies,” says Mølsted-Møller. “Most have now cleaned up that segment of their investments and are now using private equity funds, which has been added as a new asset class over the past three to five years.”

“Private equity has come in over the past five years,” agrees Per Michaelsen, senior account manager at Danske Capital. “In this house we have Danske Private Equity Partners, Nordea has a private equity fund and over the past three years we have seen foreign private equity players enter the market.”

“I see increased demand for structured vehicles with capital protection,” adds Kjær. “And investors are looking for various kinds of floaters linked to short-term interest rates now that interest rates have been going up, especially in the US, and the flat yield curves seen in both Europe and the US have increased investors’ appetite for short-term instruments. An interesting element is the capital protection; two or three years ago I would have said that we would never see the professional community buying that kind of structures, but I hear they are selling pretty well.”

But what about traditional asset classes? “In Denmark, managers like to be seen to be cutting edge, they want to explore new concepts and new ideas: transferable alpha, hedge funds and the like,” says Broby. “But there’s a difference between talking about positioning yourself as a leader at that cutting edge and implementation, and in that respect although there is a lot of activity in all of these areas and a lot of people coming through the doors and presenting these products, the old traditional asset class are still the most important. So from an asset management perspective we mustn’t lose that focus by chasing the next big thing. By remaining true to the traditional long-only asset focus on equities and bonds we can deliver what the pension funds really want as opposed to what they talk about.”

“The Danish market has been very focused on fixed income,” says Mølsted-Møller. “We have had a very big and very liquid fixed income market with the mortgage institutions, so all people working in the Danish financial sector have been very used to the fixed income market. This has had the effect that Danish pension funds weren’t very high on their equity portion. They built it up before the equity crash and then were hurt but not as much as other places.”

“Danish pension funds tend not to have a lot of equity,” agrees Michaelsen. “Here the split between equity and fixed income would be 20:80 respectively whereas in the UK, for example, it’s 80:20. The fixed income is largely made up of Danish bonds, we have a very big mortgage bond market - it’s the way we mortgage a house in Denmark - and it’s an extremely attractive class: it’s done 200 bps over euro treasuries during the past five years. But pension funds are also in euro treasuries and euro investment grades. And they have global bonds, but for these they’ll go to foreign players.”

Do foreign players represent another element of competition? “Previously, most Danish asset managers of some size were all large-cap, growthy investment funds and they suffered tremendously in 2001 to 2002 and even into 2003 and 2004,” says Kirstein. “Nordea, for example, believed in its investment style and investment process for far too long during the downturn. Then suddenly it wavered, it began having doubts about whether it was doing the right thing, should it neutralise the beta in the portfolio? So there was a lot of room for international managers, global equity managers, European equity managers. Another reason for the selection of international managers was that there was a regionalisation of the international portfolio as investors began going into Japanese equities, European equities, North American equities. So the fact that we bought more specialised asset types also meant that we used more international asset managers.”

“The bigger international asset management players have decided that they are not going to establish themselves in on a massive scale in the Nordic region, they’d rather join up with local distributors and sell products through them,” says Kjær. “If you go back three-five years, the largest and the mid-sized players went to global players on a massive scale. Now many of the institutions are discovering that there are good products to be bought from local providers.”

“We work in a global market place because all Danes speak English so anyone can come here and sell their product, there is no language barrier,” says Michaelsen. “And is there a bias towards us because we are Danish? Looking back 10 years there was a lot of bias towards relationships rather than product quality, but that is fading so there may be a limited element of this but not much and after all the pension funds are also in competition with each other and they have to go for the best products, it’s as simple as that. Of course relations mean something if you want to open a door, but on the other hand right now you also see a lot have an open door policy because they want to see what is out there.”

But there is a fiercer competition underway closer to home. “Nordea has regained its confidence and has begun vacuuming the market for the best people,” says Kirstein. “It simply went out to the Danish market saying ‘we want you, you, you and we’ll pay whatever it takes to get you’. It’s taken on maybe eight of the most prominent people in the Danish asset management industry.”

“We are a small market in terms of the concentration of asset managers, so if we are to hire skill we have either to look to our competitors or look overseas,” says Brody. “Competition for star skills could be a lot more intense. For example, we recently lost somebody to New Star in London on the Far East equity side but rather than bid up local prices and to ensure that we got the best talent we went to Stockholm and recruited someone there and transferred them to Denmark. Both we and Nordea have a culture where the documentation and audit trail is in English and in that respect it is very easy to bring in overseas talent and to relieve the pressure to a certain extent. But for sure if there is quality talent, then we are out to recruit it.”

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