Fast and slow: Finland’s Veritas makes new additions to the portfolio construction toolbox

Market manipulation by central banks has reduced the dimensions of the markets where all risky assets move in a synchronised manner and the only way out is to be in cash which has negative interest rates in the euro area, creating an asset allocation and portfolio construction nightmare for institutional investors. 

This is the sentiment of Kari Vatanen, CIO at Finnish pension insurer Veritas with assets of €4bn ($3.3bn), which he conveyed at the recent IPE Nordic Forum. Vatanen believes that while there are few diversifying asset classes in the traditional asset space, there are possibilities in illiquid assets through delayed pricing and valuation. There are also some systematic strategies that can be used both in the carry side as well as in the diversifying and tail hedging side.  

Another way of looking at diversification and portfolio construction is fast and slow investing, Vatanen says, referring to Daniel Kahneman’s book ‘Thinking Fast & Slow’.

He  explains: “There are two systems of investing. The first is fast, instinctive, emotional and sentiment driven and the second is on rational decision-making based on carefully prepared financial analysis.”

Most liquid asset classes are working in a fast trader-oriented market, based on emotional thinking. Here fundamentals are not driving market moves but rather central banks providing liquidity. The main risk to those participating in the fast market is whether or not central banks are providing enough liquidity and where liquidity injections also boost riskier assets. If they fear that liquidity is about to dry up they trade out of risky assets and vice versa. 

As a long-term institutional investor Vatanen is looking for the slower, rational decision-making process where fundamental financial analysis will help in selecting investments. “In illiquid markets there are possibilities to find more rational ways to do investments where fundamentals still matter and you can make rational decisions. The traditional way, as long as market valuations and changes in market valuations do not affect these markets too much, tends to be more rational in the current environment. Marking to market would create unnecessary noise which we do not want,” he adds.

Vatanen says an example of slow investments include private equity, even if the asset class tends to behave like listed equities and offers little correlation. “There is a phenomenon where private equity reporting typically lags listed return reports by three months. When there are rapid movements in the market this three-month delay shows an artificial negative correlation which can be beneficial for long-term investors if they have solvency requirements for risk taking,” he explains. 

The same goes for direct real estate which is not marked to market in Finland. “In Finland direct real estate is typically valued once a year when it is directly owned on the balance sheet. As we collect direct cash flows and are not forced to price them to the market as they are not available for sale, we get the smoothing effect over time,” Vatanen says.  

Vatanen has used the ‘artificial’ diversification in illiquid assets to build Veritas’s post-COVID 19 asset allocation framework, as well as some alternative risk premia (a hedge fund-like strategy that aims to harvest returns from certain risk factors).

“We have defined three types of asset classes based on their behaviour, especially their tail behaviour. We have carry-seeking asset classes which tend to have positive expected future returns. The more carry-seeking asset classes we have, the higher expected returns we have in our asset allocation. Then we need some diversifiers for risk management purposes and even tail hedges in this current environment,” Vatanen details.

The carry-seeking listed asset classes include equity, credit and emerging markets debt, and currency. “Even if we can measure quite low correlation during longer time periods they tend to be highly tail correlated with each other. If there is a crisis there are some diversification benefits in those asset classes,” he says.

In the carry-seeking asset classes there are some private asset classes as well. “Even if they are fundamentally correlated to listed assets we can get some diversification benefits in sudden market moves like in the pandemic,” he points out.

“If the marking to market comes with a delay we can use the benefit of illiquidity in pricing or valuation in those assets. We know that if there is a recession in the real economy all these carry-seeking asset classes tend to suffer at the same time but in sudden volatility spikes in listed assets, those private assets still provide some diversification benefits,” Vatanen says.

In terms of traditional diversifiers such as duration, macro hedge funds and CTAs (another hedge fund-like strategy focusing on futures trading), Vatanen is sceptical whether you can get a diversification effect by using duration in an environment of rising rates. “I am also sceptical about CTA strategies. In our studies they tend to be tail correlated to rates and if we have a high volatility in rates it might be a tough time for CTAs or any kind of trend-following models,” he adds.

Traditional diversifiers might therefore not be as reliable as they have been in the past, which has led Vatanen to consider tail hedges to secure Veritas’s solvency rate during very fast declines in listed markets. “The easiest way is to use direct option hedges but we also know that it is a very expensive way to hedge. They have a negative carry, meaning that they have a negative expected returns,” he notes.

In addition to the three asset classes (carry-seeking, diversifiers, tail hedges) Vatanen has added systematic strategies into the framework in order to get some new tools for portfolio construction.

“First of all, we can find some other sources of carry, such as volatility selling, which is another source of positive returns… but we know it is highly tail correlated to other risky assets, which means it does not provide diversification but might offer some additional returns over time,” he says.

He urges investors to challenge their investment beliefs in the changing market environment where fundamentals are no longer the driver and where central bank actions are creating volatility as they start reducing liquidity.

“There are no all-weather portfolios in the environment where rates are rising. Defensive strategies won’t work and risky asset are volatile because of the central bank manipulation. This is the strongest power in the current market environment and using Adam Smith’s terms, the invisible hand of the markets has changed to the visible hand of central banks,” he says.

Vatanen says his biggest worry at the moment is the interest-rate sensitivity in Veritas’s equity and alternatives portfolios and the effect any rapid rate rises might have on valuations. On the fixed income side he is less concerned as Veritas has reduced the sensitivity by moving towards illiquid and complex structures that provide yield without being interest rate-sensitive to developed markets, such as US Treasuries.

Rising inflation in itself is not a market variable for Veritas but central bank reactions would be. Vatanen is doubtful that the central banks will become too hawkish and sees it as positive if inflation comes to 2% or the ECB target rate. “But there is a high risk that central bank actions are too fast and risky assets cannot take it, which might cause the next recession in the next 2-3 years,” he concludes.

For the full year 2021 Veritas returned 12.6%, making it the best year of the 21st century, with equities returning 25.2%.