Pension funds on the record: A new role for alternative investments for Veritas

Our asset allocation these days consists of around one-third in listed equities, just below one-third in fixed income – which includes credit, emerging market debt and high yield – and the rest in alternatives. Our alternatives portfolio consists of 10% in private equity, 15% real estate and over 10% in hedge funds and other alternatives.  

We have recently adjusted our asset allocation, especially our alternatives portfolio, to reflect the changes in the market regime. In the years from the financial crisis to the COVID-19 pandemic, the low-interest rate policies adopted by central banks created a powerful tailwind for risky assets like equities and credit. That meant that the usual diversifiers, from high-quality bonds to macro hedge funds, did not perform at all. 

The framework changed completely in 2022, since central banks turned their policies around and started tightening. At the end of 2021 we had a higher allocation to equity but at the beginning of 2022, when it became clear that inflation was not transitory, we reduced our allocation to risky assets, starting with equities. We also reduced the duration of our fixed income portfolio. We maintained our exposure to credit, thinking that the carry element would mean that the asset class would perform better than equities.  

Redrawing the map

Last year we also started to shift our alternatives portfolio towards liquid alternatives by expanding our portfolio of hedge funds and added tail-risk hedges to the portfolio. Eventually, we carried out a comprehensive reorganisation. We started to ask ourselves what the role of alternatives in a portfolio should be. 

Any kind of alternative asset needs to have a specific reason to sit within a portfolio. We have defined three categories of alternative assets in terms of their behaviour and have organised our portfolio accordingly. The first category is assets that provide higher returns, either because of a carry effect or because they deliver cashflows. These assets tend to be less volatile within a ‘normal’ market environment, but we do not expect them to deliver any kind of diversification during recessions or times of high volatility.

The second category is assets or strategies that deliver diversification, such as macro hedge funds, systematic strategies or insurance-linked securities. These are uncorrelated with risk assets like equities and credit. We do not expect them to deliver high returns over time, because their role is to diversify the sources of return. 

The third category is strategies that deliver tail-risk hedging. We would not expect these strategies to provide a positive return during normal times and in fact the returns from these strategies may be negative. 

But we do expect these strategies to deliver positive convexity during very turbulent times in markets. Last year, we raised our allocation to these tail-risk hedging strategies. We underwrite these strategies with both asset managers and investment banks, and typically they consist of alternative risk premia and quantitative systematic strategies. 

We started to develop this framework after I joined the institution three years ago, just as the problems related to the COVID-19 pandemic were spilling onto markets. My observation was that we had too little diversification in our portfolio. I think that is quite a common problem among institutional investors – they trust that their portfolios are diversified, based on long-term correlations between asset classes. 

But there tends to be a lack of understanding of what happens to correlations during times of crisis and the effect of changing correlations on portfolios. As a result, institutions tend to be over-exposed to tail risk and therefore are usually extracting a premium from that, because hedging against tail risk is so expensive. 

“We have recently adjusted our asset allocation, especially our alternatives portfolio, to reflect the changes in the market regime”

It is very difficult to define what constitutes a normal environment in terms of correlations. Even looking back three or four decades, investors have experienced an environment where inflation was relatively low and stable and interest rates were on a declining path. 

“Any kind of alternative assets needs to have a specific reason to sit within a portfolio. We have defined three categories of alternative assets in terms of their behaviour”

In that environment, the correlation between equities and bonds was mostly negative. But in previous decades it was positive. At the same time, it is hard to say where that correlation will go now that we are in a higher inflation environment. That is why we need to be prepared and diversified. 

Style diversified 

We seek diversification in our listed equity portfolio as well. We invest directly in Nordic equities and some European equities through our internal management team, but we also invest with external active managers. In addition we have externally-managed portfolios of US equities, both active and passive. 

We also invest in ETFs with style or sector tilts to manage the risk allocation of the overall portfolio. In emerging markets, we value active management. In the future, if rates, inflation and volatility stay elevated, there will be more scope for active management. 

There is a trend of institutions seeking more concentrated equity portfolios, and this requires buy-in by the board, as well as a robust governance structure. There are two sides to the questions. Even within a diversified portfolio, one can define a risk budget for active management. Investing in a private equity portfolio, for instance, can deliver higher returns, but also carry a relatively high concentration risk. 

At the same time, in a sense almost any equity allocation can be interpreted as an active bet of some kind. Take the NASDAQ, which has delivered significantly higher alpha than the S&P over similar periods – that is a way of creating higher return expectations without running too much idiosyncratic risk.